Cost of Debt Calculation
The cost of debt is easy to calculate if they are required data. Actually, there are few methods to get the cost of debt, but some of those are more accurate some less. If you want that your result would be more accurate, you should use the first method. If it is not possible, then second, and only when first two cannot help, try the third one (this one is the least accurate).
1. The most accurate way to measure company’s cost of debt is to check on the company’s bond yield on the market. Of course, it is possible only in case when company’s bonds are traded on some exchange and mostly only the large public companies have such securities listed. If there is a possibility, you should find ‘yield to maturity’ of company’s bonds that have long maturity (at least several years).
2. Another method is to use the cost of debt formula (cost of debt = risk free rate + credit risk premium) where credit risk premium can be determined in two ways:
a. Credit risk premium is equal to the last margin which is paid for recent bank loan. Usually, when companies are taking the loan from the bank, they are paying not a constant interest rate but interbank rate (for example, EURIBOR 6M) plus some margin. And that margin, which is paid to the bank above interbank rate, can be used as a credit risk premium of the company.
b. Another way to determine the credit risk premium of the company is to use the credit rating. Not all the companies have a credit rating (large ones usually have it) which is given by some of the main rating agency as S&P, Fitch or Moody’s. If there is a rating, you should do a research which would show interest rate paid by other companies that have the same credit. Basically, you should use the first method to find the cost of debt of other companies with the same credit ratings. The interest rate paid by companies with the same credit rating should be similar; however, credit ratings must be fresh, especially if market conditions are changing, old credit ratings are useless.
3. The last and the least accurate method should be used when there are no possible data for other mentioned methods. This one is also very simple to calculate. You should check company’s income statement and to find ‘interest expenses’ (could be called also financial expenses) and in balance sheet look for ‘financial debt’ in the beginning and the end of the year. Then divide interest expenses that was paid in last year by average financial debt of the company and you will have the cost of debt. However, this calculation is very rough, especially if company’s debt or market conditions are changing fast.
When calculating the cost of debt, you should keep in mind that multinational companies have liabilities in many different currencies, and you should concentrate on the currency which is the main for your calculations (if your DCF model is in EUR then you have to calculate cost of capital in EUR).
And another important thing is timing. The cost of debt should represent the interest rate that would be paid by the company for long term debt under the market conditions in the most recent time (when you are calculating it). Old data are not accurate for this.
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