Cost of Debt

To get to the cost of debt, we first need to tackle the more fundamental question – what is debt? There’re 3 criteria of debt

1. There must be a contractual commitment to make payments. This is what separates debt from equity. When a company issues shares, the shareholders assume that the company will make dividend payments. Shareholders may even expect the company to pay dividends. But the company is not contractually obligated to make dividend payments. If the company does not make dividend payments, the shareholders can’t sue the company. But when debt is owed, there is a contractual commitment to make principal and interest payments.
   
   
2. The interest paid on debt is tax deductible.
   
   
3. If the company fails on the contractual commitments, management may lose control of the company and shareholders may lose voting rights.

So what are accounts payable, suppliers’ credit, and advance from customers? Are they debt? In the general sense, the items do not qualify as debt because neither has explicit interest expense, “explicit” being the key word here. When a company takes supplier credit, it doesn’t get discount which it would if the payment was made early. So there’s an implicit interest expense. And if a company is willing to analyze its cost of goods sold and tell us how much of those are lost discounts, then we may be able to ascertain the interest expense for those suppliers’ credit. But in absence of that information, it is very difficult to treat such items as debt. So any interest bearing liability, be it short term or long term, only counts as debt.

What of lease obligations? They are contractual commitments and are also tax deductible. If the company fails on lease commitments, it loses control of that leasehold and may even go bankrupt. So it would be wise to take lease commitments as debt as well. It doesn’t matter whether the leases are operational or capital in nature, but all lease commitments are debt.

Now coming to the cost of debt, it is the rate at which a company can borrow money for the long term today. Notice that we are interested only in the long term cost of debt. Why long term? A company may use short term loans to finance its capital needs. However, we wish to ensure that the company makes more than the rolled over cost of debt, not just the cost of debt for the next 6 months. And a long term cost of debt is a good proxy for the rolled over cost. Why today? Because we don’t care about the rate at which the company borrowed money 2 years ago. The cost of debt today is the rate at which the company can borrow money today.

The cost of debt is thus the risk-free rate plus the default spread of the company. No one should be able to borrow at lower than the risk-free rate. And the default spread accounts for the credit risk in the company. Usually, the default spread is directly given by credit rating agencies in terms of default spreads. However, if the rating is not directly available, we can estimate the default spread based on ratings of companies with similar interest coverage ratios and this gives a good idea of what the risk measures of the company are. Alternatively, the long term debt rate for a company assessed by an independent financer in the business of lending may be another good measure of the cost of debt.