Calculating Cost of Debt: YTM and Debt-Rating Approach
Cost of debt refers to the cost of financing a company using debt such as a bond issue or bank loan. It is stated as an interest rat rD. Since there is a tax shield on the interest component of debt, the component used in WACC is rD (1 –t)
In this article, we will estimate the cost of debt using two approaches: Yield-to-Maturity approach, and Debt-Rating approach.
Yield-to-Maturity Approach
The yield to maturity is the annual return from an investment purchased today and held till maturity, i.e., it is the rate at which the current market price of the bond is equal to the present value of all the cash flows from the bond.
Let’s take an example to understand this.
Assume that a company has issued a bond to raise funds.
| Par | $1,000 |
| Market value | $1,050 |
| Coupon | 8% |
| Coupon payment | Semi-annual |
| Maturity | 10 year |
The YTM will be the rate at which the present value of all cash flows = $1,050.
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