The cost of debt is the rate at which a company can borrow long-term today. It will reflect the firm’s default risk and the level of interest rates in the market. It is the sum of the risk-free rate and the default spread.
Before we delve into the cost of debt, let’s think about what debt is.
What is Debt?
Debt has to meet three criteria:
- It is a contractual commitment that must be met in good times and in bad.
- Businesses can lose control of the firm if they do not meet obligations.
- The commitment is usually tax-deductible.
Why do we need to think about debt definitionally? Lease commitments and other items that meet the above criteria should be considered as debt and incorporated into the costs of financing.
Estimating the Cost of Debt
As stated previously, The cost of debt is the rate at which a company can borrow long-term today. It will reflect the firm’s default risk and the level of interest rates in the market. It is the sum of the risk-free rate and default spread. When discussing cost of debt, it’s essential to understand if it’s a pre-tax or an after-tax measure.\[PreTaxCostOfDebt = RiskFreeRate + FirmDefaultSpread\]
Use the marginal tax rate, or the tax rate on the last dollar of income, to calculate the after-tax cost of debt:\[AfterTaxCostOfDebt = PreTaxCostOfDebt * (1 - MarginalTaxRate)\]
Estimating Firm Default Risk
The most widely used approach to estimating the cost of debt are:
- Calculate yield to maturity.
- Use a rating agency.
- Estimate a synthetic rating.
Yield To Maturity
Use the most up-to-date price and the coupon interest rate on a company’s straight bonds if they are liquid and traded, and calculate the yield to maturity. As a shortcut, you can use the =Rate formula in Excel to calculate this with the present value being a negative cash outflow. Unfortunately, most companies do not have both traded and liquid bonds.
Use a Ratings Agency
Rating agencies will provide what it sees as the default risk in the firm’s bonds. Use the median of the rating agencies estimated default spread as the firm’s default spread.
Estimate a Synthetic Rating
When neither of the above work, you can estimate a synthetic rating for the firm based upon the interest coverage ratio to determine the firm’s default risk:
- Calculate the interest coverage ratio
- Convert that interest coverage ratio into a bond rating by comparing with companies with similar interest coverage ratios that are rated
If operating income fluctuates, use your best judgment. It may make sense to average operating income when calculating the interest coverage ratio.
Adding in Additional Country Risk
Firms located in countries with a low bond rating and high default risk may bear the burden of the country default risk, especially if they are in smaller countries:\[PreTaxCostOfDebt = RiskFreeRate + FirmDefaultSpread +\ldots\\(CountryRiskEstimate * CountryDefaultSpread)\]
The country risk estimate is an estimate of how much country risk the firm will need to assume. You can look at public companies with foreign operations and back into the additional risk premium paid. If a company gets most of its revenue outside of the risky country, perhaps it only needs to assume 50% or 75% of the country risk.
Damodaran provides country default spreads and risk premiums for those not wishing to estimate the cost of debt themselves or do not have access to the data.
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