Cost of debt refers to the cost of financing a company using debt such as a bond issue or bank loan. It is stated as an interest rat rD. Since there is a tax shield on the interest component of debt, the component used in WACC is rD (1 –t)
In this article, we will estimate the cost of debt using two approaches: Yield-to-Maturity approach, and Debt-Rating approach.
The yield to maturity is the annual return from an investment purchased today and held till maturity, i.e., it is the rate at which the current market price of the bond is equal to the present value of all the cash flows from the bond.
Let’s take an example to understand this.
Assume that a company has issued a bond to raise funds.
The YTM will be the rate at which the present value of all cash flows = $1,050.
We can use a financial calculator to solve for i. In this case, i = 3.643%, which is the six-month yield. The annualized yield will be 7.286%.
Given a tax rate of 35%, the after-tax cost of debt will be = 7.286% (1-35%) = 4.736%.
For certain types of debt, we may not have the market prices readily available, for example, bank loan. In such cases, the cost of debt can be based on company’s rating by comparing it with the bonds with similar characteristics.
For example, assume that the average maturity of a company’s debt is 10 years, and the company itself has a rating of BBB.
We will first observe that the yield on debt with a similar rating is 7%. Given the tax-rate of 35%, the after-tax cost of debt for the company will be:
= 7% (1-35%) = 4.55%
The key issue here for the analyst is to identify bonds with similar debt ratings and other characteristics. For example, the issuer rating is just one of the factors while rating a debt issue. Other factors such as seniority also affect the ratings.