Cost of Capital
buttons.Cost of Debt
The cost of long-term debt, rd, is the after-tax cost of raising long-term funds through borrowing. The important cost is our marginal debt cost, which is the next dollar of debt. If we were to issue another dollar (an additional dollar) of debt, how much would it cost us? The cost of new debt issuance will probably not be the same as the cost of other debt we have
issued in the past (our historical debt cost), as we will need to satisfy the current market demand.
How to Calculate the Cost of Debt
There are a few methods to calculate the cost of debt. We are looking for the yield to maturity (YTM), since this is the most accurate gauge of market demand. How do we figure out the yield to maturity? If we have outstanding debt of an appropriate maturity, we can assume the YTM on this debt to be our cost.
If our company, however, has no publicly traded debt, we could look to the market to see what the yield is for other publicly traded debt of similar companies. Or, if we are completely using bank financing, we can simply ask the bank to provide us with an estimated rate.
Equation 12.1 Pre-Tax Cost of Debt
Component Cost of Debt = rd
Since interest payments made on debt (the coupon payments paid) are tax deductible by the firm, the interest expense paid on debt reduces the overall tax liability for the company, effectively lowering our cost. To calculate the real cost of debt, we subtract the tax liability.
Equation 12.2 After-Tax Cost of Debt
After-Tax Component Cost of Debt = rd − (rd × T) = rd × (1 − T)
Here, rd is the before-tax return, and T is the corporate tax rate.
Worked Example: Falcons Footwear
Falcons Footwear is a company that produces sneakers for children. Each sneaker has a black and red falcon head on it. The company's marginal tax rate is 40%, and it has $100 million notional, 30-year bonds with a 7% coupon. The bonds currently sell for par.
What is the after-tax cost of debt?
Since the bonds are selling for par, we know that the YTM equals the coupon rate of 7%.
After-Tax Cost of Debt for Falcon Footwear = 0.07 × (1 − 0.4)
= 0.042 or 4.2%
Key Takeaways
- The debt component has important considerations.
- Tax considerations are important as interest payments are tax deductible.
- We can estimate the cost of debt either by looking at the market or by looking at our historical debt issuances.
Exercises
- What is the cost of debt if the company has $20 million in 20 year debt that pays 11% and they are in the 40% tax bracket?
- What is the cost of debt if the company has $50 million in 10 year debt that pays 6% and they are in the 40% tax bracket?