What is the Cost of Debt?
The Cost of Debt represents the risk of the payment to of debt holders of a company. It is comprised of two risks- the probability of default and the the loss given default. The probability of default is the risk that the cash flows generated by the company would not cover the payments to the debt holders and that the company will experience an event of default. In the event of default, some of the companies assets might be sold or a debt restructure will be negotiated, to the debt holders are not expected to loose all their investment- this is the risk associated to the loss given default. The Cost of Debt is represented the the interest rate paid by the company to the debt holders. It is the rate of return that the debt holders are willing to receive for the exposure to the probability of default and the the loss given default risks.
Cost of Debt Calculation
The Cost of Debt used in the Cost of Capital (WACC) calculation should represent the interest rate paid by the company in the long term. Since the valuation of firms uses long term cash flows (on average, duration of cash flows is between 17 to 22), the cost of debt should reflect this period. Because of that, it is customary to use the debt margin- the spread between the cost of debt for a certain known duration to the risk free rate of the same duration. The debt margin is added to the long term risk free rate. For example, if a 7 year bond of a company trades in a yield of 4% and the yield of a 7 year government bond is 3% then the debt margin is 1%. In case the yield of a 20 years government bond is 3.5% we add the debt margin of 1% and receive a cost of debt of 4.5%. Also, the margin between corporate to risk free rates tends to increase as duration increases, so a use of a short term bond for the debt margin calculation may require additional adjustment for a long term margin.
Long term government bond- First of all, we need to check if the cash flow forecast used in the valuation is in nominal or real terms. In case the revenues were assessed only on the basis of change in quantity, the forecast is usually in real terms. If a change in price was taken into account it is usually in nominal terms. The government bond which we’ll use should be consistent with the assumption of the cash flow forecast, hence, nominal bond for nominal forecast and inflation adjusted bond for a real forecast. The second decision is the duration- in the past it was customary to use 10 year bonds but due to the steepness of the yield curve in recent years and because the average duration of the cash flows is around 17-22, I think it’s better to use bonds with a duration of approximately 20 years.
Company debt margin- If the debt of the company used as the benchmark is in real terms you should use the yield of inflation protected government debt and vice versa. It is best to use the longest available duration since the spread grows for longer durations. Also, since we need to use the cost of debt which best reflects the risk of the cash flows of the company, the benchmark debt should be an unsubordinated bond.
Long term duration adjustment- If you use a short term bond in the calculation of the debt margin, a long term debt margin adjustment might be required. This adjustment is added to the calculated debt margin. You can view a tutorial for the long term duration adjustment calculation.
The Debt Margin Calculator, part of the Cost of Capital Calculator found in the Analystix Tools package, can help you easily calculate the debt margin, including the long term duration adjustment. Also, if you cannot find data of a company's bond, it enables you to determine the cost of debt by using credit ratings data.