Cost of debt is the expected cost of long-term debt the company will be able to borrow today. The intrinsic value involves forecasting future cash flows and discounting them by the cost of capital. The cost of capital is the weighted average cost of debt and equity. The cost of debt should be the cost of debt of the currency in which the company is being valued.
The cost of debt is pre-tax and in nominal terms is measured as follows:
Real Interest Rate + Expected Inflation Rate + Default Spread
Hence, if the real interest rate of a country is 1%, expected inflation rate is 2% and if the company's default spread is 2.5%, then the cost of debt is 1% + 2% + 2.5% = 5.5%
Real Interest Rate
The Real Interest Rate is the rate of interest an investor or lender receives (or expects to receive) after factoring in inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.
What is a Risk-Free Rate ?
A Risk-Free Rate is a rate of return on an investment with no risk or financial loss. This is a Bond Treasury Rate issued by the government. Risk-free rates vary from country to country and currency to currency.
Risk-Free Rate = Real Interest Rate + Expected Inflation
Please note that risk-free rates vary across varying time horizons and ideally should be consistent with the forecast period while conducting valuation. If you use a different expected inflation rate in your assumptions, make sure to arrive at your own cost of debt, as inflation assumptions have to be consistent with what is assumed in risk-free rate, cost of debt, and cost of equity.
What is Expected Inflation ?
Expected Inflation is the expected inflation rate of the currency during the forecast period. It is normally built into the risk-free rate.
To elucidate, for a country in 2018, the real interest rate is 2% and the expected inflation rate is 5.25% then the Risk Free Rate should be 7.25%.Further, if a company's default spread is 2.5% then the pre-tax cost of debt is 9.75%. It is necessary to understand that the risk-free rate is real interest rate + expected inflation rate, i.e. 2% + 5.25% = 7.25%.
Interest is tax deductible
Since interest payments get a tax deduction, the cost of financing through debt is very lucrative. This saw the emergence of Leveraged Buyout Firms in the late 1980s and 1990s. Thus, while computing the cost of debt, we need to take the post-tax cost of debt.
After-Tax Cost of Debt = Cost of Debt x (1 - Income Tax)
Hence, if the cost of debt would be 9.75% and income tax rate at 33% then the after-tax cost of debt will be 9.75% x (1-33%) = 6.53%.
Example for Computing After-Tax Cost of Debt for Black Bay Pizza
Continuing with the example of Black Bay Pizza, we now compute the Cost of Debt for Black Bay Pizza in Table 9, based on the following assumptions:
Assumptions
| Expected Inflation Rate |
5% |
| Risk-Free Rate |
6% |
| Pre-Tax Cost of Debt |
8% |
| Income Tax |
25% |
Table 9 - Computation of After-Tax Cost of Debt
| Cost of Debt |
8% |
| Tax Rate |
25% |
Post Tax Cost of Debt
(8% x (1- 25%)) |
6% |