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Calculating Cost of Debt: YTM and Debt-Rating Approach

CFA® Exam, CFA® Exam Level 1, Corporate Finance

This lesson is part 4 of 12 in the course Cost of Capital

Cost of debt refers to the cost of financing a company using debt such as a bond issue or bank loan. It is stated as an interest rat rD. Since there is a tax shield on the interest component of debt, the component used in WACC is rD (1 –t)

In this article, we will estimate the cost of debt using two approaches: Yield-to-Maturity approach, and Debt-Rating approach.

Yield-to-Maturity Approach

The yield to maturity is the annual return from an investment purchased today and held till maturity, i.e., it is the rate at which the current market price of the bond is equal to the present value of all the cash flows from the bond.

Let’s take an example to understand this.

Assume that a company has issued a bond to raise funds.

Par $1,000
Market value $1,050
Coupon 8%
Coupon payment Semi-annual
Maturity 10 year

The YTM will be the rate at which the present value of all cash flows = $1,050.

\$1,050 = \left ( \sum_{t=1}^{20} \frac{\$40}{(1+i)^{t}} \right)+\frac{\$1000}{(1+i)^{20}}

We can use a financial calculator to solve for i.  In this case, i = 3.643%, which is the six-month yield. The annualized yield will be 7.286%.

Given a tax rate of 35%, the after-tax cost of debt will be = 7.286% (1-35%) = 4.736%.

Debt-Rating Approach

For certain types of debt, we may not have the market prices readily available, for example, bank loan. In such cases, the cost of debt can be based on company’s rating by comparing it with the bonds with similar characteristics.

For example, assume that the average maturity of a company’s debt is 10 years, and the company itself has a rating of BBB.

We will first observe that the yield on debt with a similar rating is 7%. Given the tax-rate of 35%, the after-tax cost of debt for the company will be:

= 7% (1-35%) = 4.55%

The key issue here for the analyst is to identify bonds with similar debt ratings and other characteristics. For example, the issuer rating is just one of the factors while rating a debt issue. Other factors such as seniority also affect the ratings.

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‹ Applications of Cost of Capital

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Issues in Estimating Cost of Debt ›

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Comments

  1. Mozammal Hoque says

    July 21, 2019 at 1:11 pm

    Hi.
    My name is Mozammal.
    I need a solution. Please.
    Given that,
    A bond has market value of 1030.44
    Coupon rate 7%, Maturity Date 8 years and Tax 35%.
    What will be the after tax cost of debt?

    Reply
    • daryl says

      March 24, 2020 at 12:23 pm

      ytm rate will be 6.5%
      after tax cost of debt will be 4.225%

      Reply

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In this Course

  • Weighted Average Cost of Capital (WACC)
  • Weighted Average Cost of Capital (WACC) – Practical Example and Issues
  • Applications of Cost of Capital
  • Calculating Cost of Debt: YTM and Debt-Rating Approach
  • Issues in Estimating Cost of Debt
  • Estimating the Cost of Preferred Stock
  • Estimating the Cost of Common Stock
  • Calculating Beta Using Market Model Regression (Slope)
  • Calculating Beta Using Pure Play Method
  • Estimating the Country Risk (Country Equity Premium)
  • Marginal Cost of Capital (MCC) Schedule
  • Flotation Costs and WACC

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