Question

DEFINE THE COST OF DEBT AND THEN INDICATE HOW THE COST OF DEBT IS ACTUALLY EMPIRICALLY ESTIMATED.

Answer 1

• Cost of debt, in definition means the 'cost' that the company has to pay on using debt as alternative for its financing need.
• When debt is issued by a company, the borrower (issuing company) is obligated to pay certain amounts of interest on that debt issued.
• This amount of interest is essentially known as the cost of debt to a firm.

To understand the empirical estimation of cost of debt, let us take the following example:

ABC Ltd. issued debt worth $ 100,000 at an interest of 5% p.a. In addition to this, the company also has bank loans worth $ 200,000 at an interest of 6% p.a.

On a yearly basis, the interest component to be paid by ABC Ltd. is:

Interest on debt issued = $ 100,000 * 5% = $ 5,000

Interest on Bank loan = $ 200,000 * 6% = $ 12,000

Thus, the total interest paid by ABC Ltd. is $17,000 for a total debt of $ 300,000

Hence, the cost of debt = 5.67% ( $17,000 / $ 300,000)

Usually, the after-tax cost of debt is taken, which is calculated as:

After tax cost of debt = Cost of debt * ( 1 - effective tax rate)

Assuming an effective tax rate of 30% for ABC Ltd,

After tax cost of debt = 5.67% * (1 - 0.30)

After tax cost of debt = 3.97%