Cost of debt refers to the cost of debt financing such as bonds and bank loans. It is estimated using either the yield to maturity approach or debt-rating approach.
Yield to maturity approach
In the yield to maturity approach, we calculate the cost of debt as the internal rate of return of the bond cash flows. When P is the price of the bond/debt, c is the periodic coupon rate, F is the face value of the bond, n is the number of coupons payments, periodic yield to maturity can be calculated by following the following equation by the hit-and-trial or financial calculator:
Debt rating approach
When a reliable market price is not available, we use the yield on comparable bonds (i.e. bonds with the same maturity and credit rating) to estimate the yield on a company’s bonds. However, since bond yield depends on a range of other factors such as seniority, collateral, covenants, care must be taken to match other features if possible. The debt-rating approach is a simpler version of matrix pricing, a more complex technique that finds yield on bonds by matching as many features as possible.
Cost of debt of floating-rate bonds and bonds with embedded options
While the aforementioned approach works fine for fixed-rate bonds, determining the cost of capital for floating-rate bonds/notes, bonds with embedded options and unrated bonds is complex. The yield on floating-rate bonds changes with changes in the general interest level. However, an attempt at estimation can be made using the term structure of interest rates. Similarly, determination of yield on bonds containing embedded options such as callable bonds, putable bonds also requires advanced valuation skills. When a company has non-public unrated bonds or no bonds, incorporating the forward-looking cost of debt would be difficult.
An analyst also needs to include the cost of lease financing in the cost of capital calculation regardless of whether it is an operating lease or a finance lease.