Cost of Debt
A company will use several bonds, loans and other forms of debt, so this criterion is useful for giving an idea as to the overall rate being compensated by the company to use debt financing. The criterion can also give investors an idea as to the riskiness of the company compared to others, due to riskier companies in general have a higher cost of debt.
The cost of debt is relatively simple to compute, as it is compiled of the rate of interest paid. In practice, the interest-rate compensated by the company can be modeled as the risk-free rate plus a risk component (risk premium), which itself comprises a probable rate of default and amount of recovery given default. For companies with interchangeable credit ratings or risk, the interest rate is largely exogenous i.e not linked to the activities of company.
The cost of debt is computed by taking the rate on a risk free bond whose time duration agrees the term structure of the corporate debt, then contributing a default premium. This default premium will rise as the amount of debt raises (as all other things being equal, the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it corresponding to the cost of equity i.e earnings are after tax as well . Thus, for profitable business firms, debt is discounted by the tax rate. The formula can be written as
(Rf + credit risk rate)(1-T),
where T is the corporate tax rate and Rf is the risk free rate.
The yield to maturity can be employed as an approximation of the cost of capital.
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