• The cost of debt  measures the current cost of the firm of borrowing funds to finance its assets
  • It should be a function of the default risk that lenders perceive in the firm
  • The default risk of a firm is a function of two variables:
  1. The firm's capacity to generate cash flows from operations; also, the volatility in these cash flows
  2. The extent of its financial obligations (interest and principal payments)
  • The most widely used measure of a firm's default risk is its bond rating assigned by the independent ratings agency
  • We can estimate the cost of debt by using their ratings and associated default spreads
  • The long term bonds outstanding of the company that are widely traded can be used to estimate the cost of debt
  • The market price of the bond can serve to compute a yield we can use as the cost of debt
Synthetic rating
  • Also applicable for unrated, smaller and private firms
  • Play the role of a rating agency and assign a rating to a firm based on its Interest Coverage ratio. 

  • Compare this ratio with the respective Rating and Typical Default Spread from the table
  • Add this Spread onto the risk-free rate to calculate a pretax cost of debt

  •  Interest is tax deductible and the resulting tax savings reduce the cost of borrowing to firms
After-tax cost of debt = Pretax cost of debt * (1 - Marginal tax rate)
  • To obtain the tax advantages of borrowing, firms have to be profitable; there is no tax advantages from interest expenses to a firm that has operating losses
After-tax cost of debt = Pretax cost of debt if operating income < 0

Pretax cost of debt * (1 - t) if operating income > 0


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