The Cost of Debt in Valuations, Credit, and Real Life

Cost of Debt Definition: The Cost of Debt in corporate finance represents the effective rate a company would pay if it issued additional Debt today; most of this cost is the Interest Expense on the Debt, but some may also correspond to discounts, penalty fees, and face value vs. market value differences. The Cost of Debt is widely used in credit analysis and to calculate WACC in a DCF model.

To a company, the Cost of Debt represents the all-in future annual “expense percentage” of additional Debt.

To an investor, the Cost of Debt is the effective annualized yield they could expect to earn over the long term by investing in a company’s Debt.

Consider a company with $1,000 of bonds and an annual interest expense of $50.

In this simple example, the Pre-Tax Cost of Debt is $50 / $1,000 = 5%.

Since the interest on Debt is tax-deductible, you multiply by (1 – Tax Rate) to use it in the WACC formula, so at a 25% tax rate, the After-Tax Cost is 5% * (1 – 25%) = 3.75%.

Of course, this is a naïve approach because we don’t know the market value of these bonds.

For example, if overall interest rates have risen since this issuance, the market value of these bonds is probably less than $1,000 now, and the company would have to pay more than 5% to issue new Debt.

As a simple example, let’s say the bonds’ market value is $900, and they have a 10-year maturity.

You could calculate the yield to maturity on these bonds with the following Excel formula to get a more accurate estimate for the Cost of Debt:

=YIELD(Today’s Date, Maturity Date, Coupon Rate, 900 / 1000 * 100, 100, 2)

Here are the results:

The yield to maturity is 6.4%, which means that if the company issued Debt today, it would have to offer a higher coupon rate because interest rates have increased.

Assessing the Cost of Debt helps companies determine how additional borrowing will affect their profitability and cash flows and lets them make Debt vs. Equity funding decisions.

It’s also widely used in Debt Schedules in 3-statement models and LBO models to estimate the interest rates on future issuances.

Files & Resources:

• Cost of Debt – Excel Examples (XL)
• Cost of Debt – Presentation Slides (PDF)
• Western Midstream Partners – 10-K Excerpts (PDF)
• Steel Dynamics – 10-K Excerpts (PDF)

Video Table of Contents:

• 0:00: Introduction
• 5:37: Part 1: Cost of Debt Interpretations
• 7:45: Part 2: Multiple Debt Issuances in Real Life
• 9:53: Part 3: No Fair Values of Debt Disclosed
• 12:24: Part 4: The Company Has No Debt
• 13:19: Recap and Summary

Interpreting the Cost of Debt: Clarifications

Before moving on, it’s worth making one more small point: If the Cost of Debt is 6.4%, as in the example above, that doesn’t necessarily mean the company will pay $64 in cash interest expense on a new $1,000 bond issuance.

Instead, it means that investors should earn a yield to maturity of 6.4%.

The company could let them achieve this by offering a lower coupon rate but a higher original issue discount (OID) or a lower coupon rate and higher call premiums or repayment penalty fees.

For example, instead of issuing a new $1,000 bond at a 6.4% coupon rate and 10-year maturity, the company could offer one of the following:

• Option #1: Issue a 6% bond at a 3% original issue discount, i.e., let investors buy it for $970 rather than $1,000. This gives them approximately 0.4% extra yield per year, boosting the YTM to ~6.4%.
• Option #2: Issue a 5% bond with a 5% repayment penalty fee and a ~7.7% original issue discount. With this method, the company limits itself to ongoing cash payments of 5% * $1,000 = $50 per year. But the investors buy the bond for only $923, still receive $50 in interest per year, and get an additional $50 when the bond is repaid.

You can see these examples below:

In most valuations and credit models, you normally assume the Cost of Debt represents the cash cost of issuing a new bond.

These alternatives are more important for stressed or distressed companies that want to restructure while reducing their cash costs.

Calculating the Cost of Debt in Real Life: Complexities and Missing Information

The calculations above are simple since they are not based on “messy” real companies.

But when you analyze real companies and estimate their Costs of Debt, you will run into a few common problems:

1. Multiple Debt Issuances – Most real companies have more than one Debt issuance, so you’ll have to calculate the YTM on each one and take a weighted average.
2. No Fair Values Disclosed – Many companies, especially smaller ones, do not disclose the fair value or fair market value of their Debt, so it’s not possible to use the YIELD function in a meaningful way.
3. No Debt – Finally, some companies may not have any Debt. In this case, you’ll have to rely on the comparable public companies and make adjustments to estimate the company’s Cost of Debt.

To illustrate these scenarios, we’ll use Western Midstream Partners (an oil & gas company in the midstream sector) and Steel Dynamics in a few examples.

Calculating the Cost of Debt in Real Life: Multiple Issuances

If the company discloses the fair value of each issuance, this issue is simple: Calculate the YTM of each one and use the weighted average to approximate the Cost of Debt.

Here are Western Midstream Partners’ disclosures:

And here are our calculations based on the weighted average YTM:

Since WES is a Master Limited Partnership (MLP), its corporate tax rate is 0% or close to 0%, which means that multiplying by (1 – Tax Rate) barely changes the Cost of Debt:

As an example for a company with corporate-level taxes, here are the numbers for Steel Dynamics:

Calculating the Cost of Debt in Real Life: No Fair Values Disclosed

If the company you’re valuing does not disclose the “fair value” or “fair market value” of its Debt, you have several options.

First, you could look at the comparable public companies, see if any of them disclose the fair value of their Debt, and base the Cost of Debt on their numbers (e.g., the median YTM for the set).

This method works, but is time-consuming and may not produce useful results if only a few companies disclose the fair values.

Second, you could take the average interest rate on the company’s Debt and use that for its Cost of Debt.

For example, with Western Midstream, we could have done the following to estimate its Cost of Debt:

This produces a 4.8% Pre-Tax Cost of Debt, which is fairly close, but it’s still a big enough difference to affect the valuation.

Finally, you could take the Risk-Free Rate and add the company’s estimated Credit Default Spread based on its credit rating.

Damodaran has an annually updated list right here, which we used for an alternative calculation:

Although WES has a high interest coverage ratio (> 3.0x and > 4.0x in some periods), both S&P and Fitch have given it a “BBB-“ credit rating.

Therefore, we took the 1.2% spread from Damodaran’s current chart and added it to the U.S. Risk-Free Rate of 4.2% at the time of this valuation to get a Pre-Tax Cost of Debt of 5.4%.

This is lower than the 5.7% YTM but is more accurate than the “simple interest expense” method.

Calculating the Cost of Debt in Real Life: No Debt

One final complexity is that you may have to calculate the Cost of Debt for a company that does not have any Debt currently.

The simple interest rate, yield to maturity, and risk-free rate + credit default spread methods do not work in this case.

All you can do here is calculate the Cost of Debt for its comparable public companies and perhaps add a “size/risk premium” if it is much smaller.

For example, you might do this if you’re valuing a tech startup and comparing it to public companies with $100+ million in revenue.

A new tech startup with low revenue is much riskier than companies with hundreds of millions in revenue, so its Cost of Debt should be higher.

Opinions vary on how much of a size/risk premium to add, but something in the 20 – 40% range might be appropriate.

So, if the public companies’ median YTM is 8%, perhaps your company’s Cost of Debt is 10% or 11%, representing premiums in that 20 – 40% range.