Cost of Debt

Learning Objectives
  1. Understand the components of the cost of debt.
  2. Identify the tax implications of debt.
  3. Explain how debt plays into the weighted average cost of capital.

The cost of long-term debt, r{d}, 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 issuance of debt will probably not be the same as 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 = r_{d}

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 take out the tax liability.

Equation 12.2 After-Tax Cost of Debt

After-Tax Component Cost of Debt = r_{d}-\left(r_{d} \times T\right)=r_{d} \times(1-T)

Here, r_{d} 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. Their marginal tax rate is 40%, and they have $100 million notional, 30-year bonds with a 7% coupon. The bonds currently sell for par. What's 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 \times(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
  1. What's 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?
  2. What's 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?

Source: https://2012books.lardbucket.org/books/finance-for-managers/s12-02-cost-of-debt.html
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