Cost of Debt
Cost of debt is the rate of return required by a business' debt holders. It is normally estimated as the yield to maturity on a business' bonds payable.
It is important for a business to estimate it cost of debt because after-tax cost of debt which equals before tax cost of debt multiplied by (1 − tax rate), is an important input in the calculation of weighted average cost of capital.
Cost of debt is estimated by calculating the yield to maturity on the debt which is calculated by solving the following equation:
|Current Market Value of Debt = Coupon Payment ×||1−(1+r)-n||+||Face Value of Debt|
|Coupon Payment =||Stated Rate on the Bond||× Face Value of Debt|
|Number of Payments per Year|
|r =||Yield to Maturity|
|Number of Periods per Year|
|n = Number of Coupon Payments = Number of Periods per Year × Maturity in Years|
Cost of debt is then expressed as an annual APR i.e. cost of debt is equal to number of payments per year times r.
In rare situations when it is not feasible to estimate yield to maturity, current yield and coupon rate are used as estimates for cost of debt.
Lockheed Martin Corporation has $900 million $1,000 per value bonds payable carrying semi-annual coupon rate of 4.25%. They are maturing on 15 November 2019. The bonds have a market value per bond of 112.5 as at 15 November 2012. If the tax rate is 35%, find the before tax and after tax cost of debt.
Before tax cost of debt equals the yield to maturity on the bond. Yield to maturity is calculated using the IRR function on a mathematical calculator or MS Excel. Semiannual yield to maturity in this example is calculated by finding r in the following equation:
|$1,125 = $21.25 ×||1−(1+r)(-2×7)||+||1|
r comes out to be 1.15%. Relevant annual before tax cost of debt is just the relevant APR which his 2.3% (2 times 1.15%)
Corresponding after tax cost of debt is 1.495% (2.3% × (1 − 35%)).
Written by Obaidullah Jan