Estimating the Cost of Debt

Analysts use several methods to estimate the cost of debt, and the methods depend on the following factors:

• Type of debt.
• Debt liquidity.
• Credit rating.
• Debt currency.

Traded Debt

A company with straight debt can estimate its cost of issuing debt and the yield to maturity on its existing debt with the longest maturity. For a company with more liquid shorter-term bonds whose trades are more frequent than its longest-dated bond, the shorter-term debt’s YTM will be a better estimate of its cost of debt.

Non-traded Debt

In the case of non-traded debt, a quoted YTM is either an unreliable estimate of a company’s debt cost or nonexistent altogether. In this case, an analyst needs to check if the credit ratings of the company’s bonds exist. The analyst will then estimate the company’s cost of capital by using the YTM of comparable bonds with similar credit ratings and maturities. After this, they will apply matrix pricing to estimate the subject company’s bond’s YTM.

Where no credit rating exists, the analyst can use a company’s fundamental characteristics to get a synthetic rating or the bond’s likely rating. Once the analyst has deduced the credit rating, they can estimate the cost of debt using the deduced credit rating and the YTM of similarly mature bonds. The analyst can also determine the credit spread for the maturity and credit rating of the company’s debt. The analyst adds the benchmark risk-free rate to the credit spread to derive an estimated debt cost.

Bank Debt

Due to their lower default risk, amortizing loans have a lower debt cost than non-amortizing loans. The interest rate of a company’s debt is a good place for an analyst to begin to estimate the cost of bank debt. Suppose a company’s risk profile hasn’t materially changed since a debt was issued; interest rates are an indication of current market conditions. An analyst can, therefore, use interest rates as an estimate of such a company’s cost of debt.

Leases

We have two types of leases, finance and operating leases. For a finance lease, the lessee owns the asset at the end of the lease term. The capital for operating leases is not capitalized in the financial statement of the lessee. The interest rate on a finance lease can be derived from the leased asset’s fair value and lease payments. Generally, leases have lower borrowing cost compared to borrowing from capital markets.

According to ASC-842 and IFRS-16, the RIIL (rate implicit in the lease) or interest rate is:

$$ \text{Present value of lease payments + Present value of residual value to lessor = Fair value of leased asset + Lessor’s direct initial costs} $$

If the lessor’s direct initial costs and the present value of the residual value are unknown to the lessee, we use the incremental borrowing rate (IBR). IBR is the interest rate that a company pays to borrow a collateralized loan over a similar term. If the IBR is unknown, the analyst uses the non-debt traded method of estimation. Different tax jurisdictions consider a finance lease a purchase; thus, interest expense is tax deductible. In such instances, the cost of debt needs to be adjusted to put it on an after-tax basis.

International Considerations

The cost of debt should reflect the currency in which its cashflows occur when it is estimated for international markets. One estimation method is adding the debt’s yield to the country’s risk premium. In such an instance, country risk rating (CRR) is used. CRR is applied to a country based on the risk assessment related to it (the country) in the following areas:

1. Political risk.
2. Economic conditions.
3. Securities market development and regulation.
4. Exchange rate risk.

An analyst assesses risks relative to the sovereign debt risk of a country. They then use this information to adjust the cost of debt of a company. The ratings are often similar to credit ratings (e.g., 0 to 100, 0 to 10, AAA, AA). The median interest rate can be calculated from each rating class.

Question

Marylin estimates the cost of debt for a company that leases its asset. Which of the following pieces of information is least likely useful in estimating the cost of debt?

1. The residual value of the leased asset.
2. YTM of bonds – similar bonds with a similar maturity.
3. The fair value of the leased asset.

Solution

The correct answer is B.

The YTM of bonds with a similar is used to estimate the cost of debt of non-traded debt.

A and C are incorrect. These are useful in the estimation of the cost of debt for leases.

Reading 20: Cost of Capital: Advanced Topics

LOS 20 (b) Compare methods used to estimate the cost of debt.