In this article, I will show you how to calculate and interpret the cost of debt for a company. The cost of debt is a fundamental concept in corporate finance, affecting a company's capital structure and financial health by representing the effective interest rate on its debt obligations. Additionally, it serves as a key component of the Weighted Average Cost of Capital (WACC), which considers the cost of debt, the cost of preferred stock, and the cost of equity, as well as their respective weights, to assess a company's overall financing cost.

This article provides a detailed and comprehensive exploration of calculating a company's cost of debt. It discusses the premise of the cost of debt, explains the five core methods used for its calculation, and demonstrates these methods with real-world examples. It then concludes by discussing the tax shield and how to apply it to calculate the after-tax cost of debt.

Cost of Debt Explained

The cost of debt is the effective interest rate that a company must pay on its long-term debt obligations, representing the minimum yield lenders expect to compensate for the risk of lending. This rate fluctuates with the company's credit profile and market conditions, providing insights into the company’s risk profile, where higher rates suggest greater perceived risks by lenders.

Thus, the cost of debt plays an important role in determining a company's creditworthiness and its ability to manage its capital structure effectively. It impacts the company's strategy to balance borrowing costs with potential returns on investment, influencing decisions on whether to finance operations or growth through debt or equity to maximize shareholder value.

The cost of debt is also calculated both before and after taxes, with the after-tax cost being particularly significant for determining the Weighted Average Cost of Capital (WACC). The WACC serves as the standard discount rate in valuation models like the discounted cash flow (DCF). The deductibility of interest expenses from taxable income results in tax savings, effectively lowering the borrowing cost, and highlighting the tax efficiency of debt financing in corporate capital structure.

Factors Influencing the Cost of Debt

The cost of debt is influenced by several dynamic factors, each playing an important role in determining the interest rate a company pays on its borrowings. These factors can vary over time, leading to fluctuations in the cost of debt and impacting the company's financial strategy and operational decisions.

Below are the key factors that influence the cost of debt:

• Creditworthiness: The better a company's credit rating and financial health, the lower its cost of debt due to reduced lender risk.
• Economic and Market Conditions: Prevailing interest rates, set by central bank policies and influenced by economic conditions, directly affect borrowing costs. Market demand for corporate bonds and inflation expectations also play critical roles.
• Industry Risks: The perceived risk and volatility within an industry can lead to higher borrowing costs for companies operating in sectors considered less stable.
• Debt Terms and Conditions: Specifics such as maturity length, fixed versus variable interest rates, and the presence of covenants can alter the cost of debt.
• Regulatory Environment: Changes in regulations that affect lending and borrowing practices can impact the cost of borrowing for companies.
• Company-Specific Events: Internal events, including management changes, strategic shifts, or operational challenges, can affect a company's perceived risk and its borrowing costs.

To illustrate the dynamic nature of the cost of debt, consider a scenario where a bank lends $5 million to a company at a 5.0% annual interest rate with a 10-year maturity. The 5.0% rate, agreed upon in the past, might not reflect the company's current cost of debt due to changes in market conditions or the company's creditworthiness since the loan was originated. This is where the cost of debt calculation methods, detailed below, come into play, aiming to accurately measure this cost.

Five Methods for Calculating the Cost of Debt

There are five main methods to calculate the cost of debt for a company. The methods we'll discuss are the Yield to Maturity (YTM), Current Yield, Debt Rating, Synthetic Debt Rating, and Interest Expense to Total Debt.

In this section, we'll explore these methods in detail, using Salesforce (CRM) as our example. Salesforce is a global leader in customer relationship management (CRM) software, offering cloud-based applications to help businesses connect with their customers.

After discussing these methods, we'll demonstrate how to apply the tax shield to calculate the after-tax cost of debt. This step is crucial for financial valuations and other applications, as it reflects the actual cost of debt to a company after considering the benefits of interest expense deductions on taxable income.

Method #1: Yield to Maturity (YTM)

The yield to maturity (YTM) method is a widely recognized approach for calculating the cost of debt, particularly for companies that include bonds in their debt portfolio. YTM signifies the total return anticipated by an investor who buys a bond at present and retains it until its maturity. This method is deemed the most precise for determining a company's current cost of debt, since bond values and their corresponding YTM rates fluctuate daily, effectively mirroring the cost of debt.

The YTM formula is shown below:

YTM = [C + (FV - PV) / N] / [(FV + PV) / 2]

where:

• C = annual coupon payment
• FV = face value of the bond
• PV = price of the bond
• N = years to maturity

This method integrates the bond's current market price, face value (par), coupon interest rate, and time to maturity into a single measure, offering a detailed projection of the annual return over the bond's lifespan. By accounting for all cash flows, including coupon payments and the variance between the bond's face value and market price, YTM provides a precise calculation of the bond's yield through its term.

For an example, consider a bond with the following characteristics:

• Annual Coupon Payment (C): $100 (10% coupon rate)
• Face Value of the Bond (FV): $1,000
• Price of the Bond (PV): $950
• Years to Maturity (N): 10

The YTM calculation based on these parameters is shown below:

YTM = [$100 + ($1,000 - $950) / 10] / [($1,000 + $950) / 2] --> 0.1077 or 10.77%

The YTM, expressed as a decimal, is 0.1077, which translates to a yield to maturity of ~10.77%. This means if an investor buys the bond for $950 and holds it until maturity, they can expect an annual return of about 10.77% (pre-tax).

Note, a bond's market price relative to its face value impacts its YTM, affecting overall returns. Here's how this relationship affects the YTM:

• Bond Price < Face Value: The YTM will be higher than the coupon rate due to the bond being purchased at a discount. The investor benefits from both the annual coupon payments and capital appreciation upon maturity, increasing the overall yield.
• Bond Price > Face Value: The YTM will be lower than the coupon rate as the bond is bought at a premium. This results in a capital loss when the bond matures at its lower face value, which diminishes the effect of higher coupon payments.

Now, for a more precise calculation, investors can use the model linked below, which relies on the Excel "=RATE" function instead of the YTM formula shown above:

In this model, we use the same bond values and obtain a YTM of 10.84% using the =RATE function, compared to 10.77% with the simplified YTM formula (both on a pre-tax basis). This discrepancy arises because the =RATE function accurately incorporates compounding interest and accommodates different payment frequencies, offering a more detailed assessment of a bond's yield to maturity than the simplified approach.

For reference, here are the required inputs in the =RATE function to calculate the YTM:

YTM = RATE(Number of Periods (Coupons Per Year × Years to Maturity), Coupon Payments ((Face Value of Bond (Par) / Coupon Rate (Annual)) / Coupons Per Year), -Current Price of Bond, Face Value of Bond (Par)) × Coupons Per Year

Salesforce YTM Example

When calculating the YTM for a real company, which often has multiple outstanding bonds, the process becomes more involved. It involves a series of steps that include collecting detailed information on each bond issued by the company. The steps below describe how you can approach this task.

Step #1: Gather Bond Information

Begin by gathering data on all the company's outstanding bonds. Professional investors might access this information through financial data providers such as Bloomberg and FactSet. However, retail investors can utilize alternative resources to find all relevant corporate bond information for the company:

• FINRA's Corporate and Agency Bonds: This platform provides detailed data on individual bonds, including maturity dates, coupon rates, credit ratings, and market prices.
• 10-K Annual Reports: Companies disclose their financial conditions and debt structures in these comprehensive reports. Investors can glean information about total debt, bond terms, interest rates, and maturity periods by examining the 10-K filings.
• Markets Insider: This website is particularly useful for its information on bond issue volumes, various bond dates, and the number of coupon payments per year.

We'll use Salesforce (CRM) for our company example. Below, you can see that I searched for "Salesforce" on FINRA and then applied a filter to list only active bonds that have not yet matured:

Referencing Salesforce's most recent 10-K annual report, under the "Notes to Consolidated Financial Statements," there is a debt section detailing the company's current borrowings:

Now, if we focus solely on the company's current corporate bonds that have not yet matured, these will be the 7 listed bonds previously shown on FINRA. These bonds will be used to calculate the weighted average YTM for Salesforce.

Begin by creating a table in Excel that includes the following required information for calculating the YTM:

You can also reference the Excel model linked below, which covers steps #1-3 as well:

Step #2: Calculate YTM for Each Bond

Given the information at hand, the "=YIELD" Excel function will be utilized instead of the "=RATE" function to calculate the YTM of every bond. The difference is that the "=YIELD" function is specifically designed to calculate the yield of a bond based on its price, whereas the "=RATE" function is more general, calculating the interest rate of an investment.

For reference, here are the required inputs in the =YIELD function to calculate the YTM:

YTM = YIELD(Settlement Date (or Date of Issuance if not available), Maturity Date, Coupon Rate, Latest Sale Price, 100, Coupons Per Year)

Here's how the table should look now, with the YTM calculation completed:

Step #3: Calculate Weighted Average YTM

Finally, since Salesforce has multiple outstanding bonds with different YTMs, we need to calculate the weighted average YTM to get an accurate understanding of the company's overall cost of debt from its bonds.

To do this, multiply the outstanding principal balance by the calculated YTM for each bond to obtain a weighted YTM figure. Then, sum this column (across all 7 bonds) to get a total amount. In our case, this totals $388.33. Next, sum the outstanding principal balances for each bond. In our case, this totals $9,500.

Here's how the final table should look:

Dividing the total weighted YTM value by the total outstanding principal balance yields the YTM cost of debt, which is 4.09% ($388.33 / $9,500). Thus, this 4.09% is considered the pre-tax cost of debt for Salesforce, based on the weighted YTM approach.

Method #2: Current Yield

The current yield method offers a simpler alternative to the yield to maturity (YTM) for evaluating the cost of debt, particularly for bonds. Its formula is shown below:

Current Yield = (C / PV) × 100%

where:

• C = annual coupon payment
• PV = price of the bond

The current yield method provides an immediate measure of the income return on a bond, expressed as a percentage of the bond's market price. It focuses on the annual income an investment generates, disregarding potential future capital gains or losses.

This makes it a straightforward metric, though it does not capture the total returns over the bond's lifespan, which may limit its accuracy for comprehensive cost assessments.

Salesforce Current Yield Example

For our Salesforce (CRM) example, to obtain a single cost of debt figure and calculate the current yield for all outstanding bonds, we can set up the table as follows:

You can also reference the Excel model linked below, which covers this example as well:

The coupon amount and actual sale price columns are calculated with the assumption that the face value of each bond is $1,000. The current yield is determined by dividing the coupon amount by the actual sale price of the bond. To calculate the weighted current yield for each bond, we multiply the bond's outstanding principal by its current yield.

Then, similar to the weighted YTM approach, the weighted current yield for the cost of debt is found by dividing the sum of the weighted current yields of all bonds by the sum of their outstanding principals. In our scenario, this calculation yields 3.23% ($307.06 / $9,500). Therefore, this rate is regarded as the pre-tax cost of debt for Salesforce, following the current yield method.

Method #3: Debt Rating

The debt rating approach to calculate the cost of debt is predicated on the premise that a company's creditworthiness, as evaluated by credit rating agencies like Standard & Poor's (S&P), Moody's, or Fitch Ratings, has a direct impact on the interest rate or yield that investors require to hold the company's debt. This method is particularly relevant for companies with publicly traded debt.

The debt rating formula is relatively straightforward, as shown below:

R_d = R_f + Default Spread

where:

• R_d = pre-tax cost of debt
• R_f = risk-free rate

Here, the risk-free rate (R_f) is typically represented by the yield on government securities, such as U.S. Treasury bonds, which are considered free of default risk. The default spread is the additional yield that investors require to compensate for the risk of default associated with the company's debt, as indicated by its credit rating.

To estimate the cost of debt using this method, follow these two steps:

1. Determine Credit Rating: Identify the company's current debt rating from a recognized credit rating agency (e.g., Moody's, S&P, Fitch, etc.).
2. Reference Market Yields: Refer to the current market yields for bonds that have similar ratings and maturity to estimate the cost of debt. This reflects the market's perception of the company's credit risk.

When selecting the risk-free rate, it's important to match the maturity of the rate to the average maturity of the company's debt. For example, if the company's debt has an average maturity similar to a 10-year bond, the yield on the 10-year U.S. Treasury bond would be an appropriate choice. These rates can be found on the U.S. Department of the Treasury website.

For the default spread, one can look at the additional yield over the risk-free rate that bonds with a similar credit rating are commanding in the market. This spread can be found in financial databases and market reports that track bond yields according to rating categories.

Salesforce Debt Rating Example

One approach retail investors can utilize for calculating the cost of debt, via the debt rating method, is to reference corporate bond yields matching the company's credit rating. For example, Salesforce, with "A2" and "A+" ratings from Moody's and S&P respectively, can estimate its cost of debt by referring to sources like FRED and YCharts.

These platforms offer indices that track the effective yield of corporate bonds across different investment grades. The methodology involves subtracting the risk-free rate, usually the yield on the 10-year U.S. Treasury, from the respective effective corporate bond yield, to calculate the default spread. This rate is then added back to the risk-free rate to calculate the pre-tax cost of debt.

Now, here's the current yields for the AA U.S. Corporate Index Effective Yield and U.S. 10-Year Treasury Rate:

• AA U.S. Corporate Index Effective Yield: 4.92%
• U.S. 10-Year Treasury Yield: 4.17%

These rates are also visualized in the live chart below (each on their own price scale):

Using these rates, we'd calculate the default spread for Salesforce as follows:

Default Spread [CRM] = 4.92% - 4.17% --> 0.75%

This spread of 0.75% reflects the extra yield investors require to compensate for Salesforce's credit risk compared to a risk-free investment. This spread is then added to the risk-free rate to estimate Salesforce's cost of debt.

R_d [CRM] = 4.17% + 0.75% --> 4.92%

The exact match of 4.92% between the calculated pre-tax cost of debt and the AA U.S. Corporate Bond Effective Index Yield confirms Salesforce's market-assessed credit risk. This approach validates that the premium over the risk-free rate mirrors Salesforce's credit risk premium accurately.

However, this alignment might not always hold, especially in volatile markets or with financial shifts in the company. In such cases, the default spread may not fully capture current risks, making it beneficial to perform these calculations for a nuanced understanding, rather than relying solely on matching yield indexes.

Method #4: Synthetic Debt Rating

The synthetic debt rating approach offers an innovative methodology for estimating a company's cost of debt, particularly useful in scenarios where an explicit credit rating is unavailable. This technique becomes invaluable when traditional methods such as yield to maturity (YTM) or direct debt-rating evaluations are not feasible due to the absence of a bond or credit rating, or when the company has multiple ratings, complicating a straightforward analysis.

The formula for this approach mirrors that of the debt rating approach but with a key distinction; it utilizes the estimated synthetic rating spread instead of the default credit rating spread. The synthetic debt rating cost of debt formula is shown below:

R_d = R_f + Estimated Synthetic Rating Spread

where:

• R_d = pre-tax cost of debt
• R_f = risk-free rate

This approach, developed by Professor Aswath Damodaran, capitalizes on a company's financial ratios and operational characteristics to simulate a credit rating, referred to as a "synthetic" rating.

Similar to the traditional debt rating method, the synthetic debt rating approach assesses a company's default risk. However, it diverges by using internal financial metrics rather than external credit ratings to deduce a rating. This deduced rating is subsequently used to estimate the cost of debt, providing a structured alternative for determining borrowing costs, especially in situations where direct credit assessments are not possible.

Now, here are the steps to follow this approach, as we'll demonstrate with Salesforce further below:

1. Calculate the Company's Interest Coverage Ratio: Use the interest coverage ratio formula (EBIT / Interest Expense) to evaluate how well the firm can cover its interest expenses with operational earnings. A higher ratio signifies strong earnings relative to interest costs, indicating lower credit risk and a potential for a better synthetic credit rating.
2. Determine the Synthetic Rating Using Damodaran’s Tables: Link the interest coverage ratio to a synthetic credit rating using Damodaran’s tables. These correlate ratios with hypothetical credit ratings and their default spreads, based on an analysis of rated companies in the U.S. and market bond trades.
3. Estimate the Cost of Debt: Calculate the pre-tax cost of debt by adding the risk-free rate to the synthetic rating spread.

Salesforce Synthetic Debt Rating Example

Continuing with our Salesforce example, the first step involves calculating the interest coverage ratio using income statement numbers from its most recent fiscal year 2023 10-K annual report, as shown below:

Interest Coverage Ratio [CRM] = $1,030 / $277 --> 3.27x

This ratio indicates that the company earns 3.27 times its interest expenses, suggesting a solid, though not outstanding, financial position.

Next, we consult Damodaran's table, which relates interest coverage ratios to default spreads for non-financial services firms like Salesforce. According to this table, a 3.27x interest coverage ratio aligns with a credit rating of A3/A-. This corresponds to an estimated synthetic rating spread of 1.21%, as shown in the table below:

Finally, by adding this synthetic debt rating to the previously identified U.S. 10-year risk-free rate, we can calculate the company's pre-tax cost of debt as follows:

R_d [CRM] = 4.17% + 1.21% --> 5.38%

Thus, this 5.38% rate represents the pre-tax cost of debt for Salesforce, based on the synthetic debt rating approach.

Method #5: Interest Expense to Total Debt

The interest expense to total debt method offers a straightforward approach for calculating a company's pre-tax cost of debt. Its premise lies in providing an uncomplicated way to determine the average cost of borrowing across all types of debt a company might have. By dividing the total interest expense by the total debt, this method yields an average interest rate, offering a broad overview of a company's debt cost.

The formula to calculate the pre-tax cost of debt using this method is shown below:

R_d = Annual Interest Expense / Total Debt

where:

• R_d = pre-tax cost of debt

The effective interest rate, calculated by this formula, reflects the average rate at which a company finances its debt. It divides annual interest expenses, the total yearly payments on debt, by the sum of all short-term and long-term obligations from the balance sheet, offering a blended view of the company's borrowing costs.

Although this formula is easy to implement, it may not accurately reflect the cost of each type of debt because it averages the interest cost across various debt instruments with potentially different rates and terms. Furthermore, this method does not account for differences in loan structures, maturities, and covenants that can significantly affect the cost of debt. It is therefore considered the weakest cost of debt calculation method.

Salesforce Interest Expense to Total Debt Example

The pre-tax cost of debt for Salesforce, based on its fiscal year 2023 10-K annual report, can be determined by referencing the income statement for interest expense and adding the company's short-term and long-term debt obligations to calculate the total debt. The formula is applied as follows:

R_d [CRM] = $277 / $14,088 --> 0.0196 or 19.6%

Thus, this 19.6% rate reflects the company's pre-tax cost on its total debt, offering a broad view of its borrowing expense. Notably, this figure significantly deviates from the results of the four other cost of debt methods discussed for Salesforce in this article. Such a notable difference highlights the method's imprecision, as it fails to accurately capture the cost associated with each type of debt due to its fundamental simplicity and reliance on averaging.

How to Apply the Tax Shield to Calculate the After-Tax Cost of Debt

Understanding the after-tax cost of debt is a must for accurate financial analysis and decision-making. While the pre-tax cost of debt provides insight into the interest expense a company faces before accounting for taxes, the after-tax cost of debt offers a more precise measure of the actual expense, considering the tax benefits associated with interest payments.

The after-tax cost of debt is particularly relevant in evaluating investment decisions, capital structure, and financial planning. Interest expenses on debt are tax-deductible, reducing the company's taxable income and thus its tax liability. This tax deductibility acts as a "tax shield," making debt financing more attractive in certain contexts by effectively lowering the cost of borrowing.

The formula to calculate the after-tax cost of debt is shown below:

After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 - Tax Rate)

Here, the pre-tax cost of debt represents the interest rate a company pays on its total debt before taxes, calculated using one of the five cost of debt calculation methods discussed above. The tax rate is the effective corporate tax rate applicable to the company. It can typically be found in the company's 10-K annual report or can be calculated using the formula below:

Tax Rate = Income Tax Expense / EBT (Earnings Before Taxes)

Here's how the calculation would apply for Salesforce (CRM):

Tax Rate [CRM] = $452 / $660 --> 68.5%

This is also shown under the "Notes to the Financial Statements" section on the company's 2023 10-K annual report:

To be more conservative and considering the unusually high effective tax rate of 68%, we'll use the FY 2022 6% effective tax rate instead. If we apply this rate to the pre-tax cost of debt calculation method outputs we found earlier, we'll get the following results for the company's after-tax cost of debt:

These after-tax costs of debt indicate that, after accounting for the tax shield, the company's effective cost of borrowing is lower than the nominal interest rate it pays on its debt. This adjusted cost provides a more accurate basis for comparing the benefits of debt versus equity financing, as it reflects the tax advantages of debt.

The Bottom Line

The cost of debt is the effective interest rate a company pays on its debt. It influences the Weighted Average Cost of Capital (WACC) and, consequently, investment and valuation decisions. Factors such as creditworthiness, market conditions, industry risks, debt terms, and regulatory changes dynamically impact the cost of debt.

Five methods determine the cost of debt: Yield to Maturity (YTM), Current Yield, Debt Rating, Synthetic Debt Rating, and Interest Expense to Total Debt. Each offers distinct perspectives, from analyzing bond returns to estimating borrowing costs via market or synthetic ratings, accommodating various analytical needs and data scenarios.

Calculating the after-tax cost of debt is also important because it not only refines WACC for valuation efforts like discounted cash flow analysis but aids in strategic financial planning. This adjustment allows companies to precisely optimize their financing mix, utilizing debt and equity to achieve maximum capital efficiency and enhance shareholder value.