What is the Cost of Debt?
Cost of debt is the required rate of return on debt capital of a company, for example its bonds and loans. Where the debt is publicly traded, the cost of debt is the yield to maturity (YTM) of the debt. It is the required return by debtholders and is often represented as Kd. Cost of debt is a key part of a company’s capital structure.
Capital structure represents the proportion of debt and equity used by the business to fund its operations and growth. This is ordinarily a mix of debt, such as debentures, loans and corporate bonds, and equity financing.
Analysts calculate the cost of debt as part of the WACC of a target company. This reflects the return required by all providers of capital to compensate for the risk profile of the underlying assets. The return calculation is very sensitive to cost of debt and cost of equity calculations, and accuracy is often difficult.
Key Learning Points
- Cost of debt is the return on debt capital and is often denoted as Kd
- The cost of debt should be tax adjusted at the marginal tax rate because interest is tax deductible
- Debt is an amount of money borrowed by one party to the other under the condition that it is repaid at a later date
- When calculating the cost of debt, only the most recent figures should be used and balance sheet numbers should be used as a last resort
Calculating the Cost of Debt
The formula for cost of debt is how shown below. It is tax adjusted using the marginal tax rate to arrive at an after-tax rate:
Cost of debt = Kd + (1 – MTR)
The marginal tax (MTR) rate is the rate on the next dollar/pound/yen of earnings. We do not want to use the effective tax rate.
To find the cost of debt, you must first sum the total yield on all debt by the company during the financial year and divide it by the total issuances of debt for the same period. Only the latest available debt figures should ever be used. This means we want to avoid debt balances on the financial statements as these are outdated. Below is a list of the best sources of information for debt issuance:
- Yield to maturity on publicly traded debt (use market observed data)
- Risk free rate (Rf) plus an appropriate credit spread
- Benchmark to comparable companies with similar credit rating and / or leverage
Ideally, publicly traded debt from the company in question will provide the most accurate source of information. This, however, is not always possible if the debt is not publically traded and reviewing benchmarks to similar credit is the next best option. For all cases, always use the market value of the debt in the calculation (and not the book value). Once computed, the tax rate needs to be taken into consideration as interest is tax-deductible and recognized as an expense in the income statement. Let’s walk through a simple example.
A company has a bank loan of 5,000,000 on which it pays interest at 4%. It has a second loan with a different bank of 1,000,000 on which it pays interest at 7%. The interest paid during the year on the first loan is 200,000, and the interest paid on the second loan is 70,000. The effective interest rate is 4.5% (270,000 divided by 6,000,000), which is the cost of debt. The company’s tax rate is 20%, therefore the after-tax cost of debt is 3.6% (4.5% effective interest rate multiplied by 1 minus the tax rate of 20% = 3.6%).
How is Cost of Debt used in the WACC?
Cost of debt, along with cost of equity, make up a company’s capital structure. When the cost of debt is multiplied by the proportion of debt in a company’s capital structure, and the cost of equity is similarly multiplied by the proportion of equity, you reach the Weighted Average Cost of Capital, or WACC.
When looking at the WACC, it’s helpful to remember that the cost of debt is usually lower than the cost of equity. The cost of equity is the return that shareholders expect on their investment to compensate for the risk profile. If the cost of debt is higher, it could indicate that the company is in a poor credit position as it has had to agree to high interest on its debts in order to secure financing.