A company may finance its operations in one of two ways, by releasing equity (selling shares) or by taking out loans or issuing bonds (debt). Equity is seen as more expensive as it dilutes the current shares and is not tax-deductible, but equity does not need to be repaid as debt does.
Where as startups often rely on equity to finance its operations, by releasing equity to venture capitalists, more established companies often rely on debt as it is seen as cheaper, and they can pay back the loans with the profits from operating.
The cost of debt is an input to calculating the weighted average cost of capital (WACC), which itself is a useful metric in comparing a company's return on invested capital (ROIC).
We need to get the pre-tax cost of debt before we can calculate the after-tax cost of debt. The total interest can be calculated more than one way as well, which we will explain further down in our example with 3M.
Cost of debt = total interest / total debt
The benefit of using debt to finance operations is that it is tax-deductible. The weighted average cost of capital (WACC) uses the tax-deductible form of cost of debt in its calculations. We use the tax-deductible result because it is inline with other inputs to the WACC, so we are not mixing deducted and non-deducted inputs.
Cost of debt = interest rate × (1 - effective tax rate)
Let us use a worked example on a real company. We will work out the cost of debt for 3M using their 2020 annual report which can be found here
As mentioned above, the after-tax cost of debt is the formula we will use as it is required as an input to WACC. First we need to calculate the interest rate.
To get an accurate interest rate we should use the weighted average of all outstanding debts. On page 88 of 3M's annual report there is a table listing all current long-term debt. Among other items the table lists inputs for our needs, the 'amount' (carrying value) and 'interest rate'.
Lets say we have three debts, debt A, debt B and debt C, our calculation for weighted average interest rate would be:
Weighted average interest = [(debt A interest × debt A amount) + (debt B interest × debt B amount) + (debt C interest × debt C amount)] / (debt A amount + debt B amount + debt C amount)
Looking at the table on page 88 we will take the effective interest rate and multiply it by the amount (carrying value) for 2020 for each row.
| Amount | Interest | Amount × Interest |
|---|---|---|
| 374 | -0.28 | -1.0472 |
| 367 | 1.97 | 7.2299 |
| 612 | 0.45 | 2.754 |
| 598 | 2.17 | 12.9766 |
| 449 | 2.76 | 12.3924 |
| 731 | 1.14 | 8.3334 |
| 649 | 2.26 | 14.6674 |
| 498 | 1.86 | 9.2628 |
| 299 | 0.52 | 1.5548 |
| 299 | 3.3 | 9.867 |
| 502 | 2.98 | 14.9596 |
| 548 | 3.04 | 16.6592 |
| 744 | 2.12 | 15.7728 |
| 498 | 2.67 | 13.2966 |
| 908 | 1.66 | 15.0728 |
| 644 | 2.37 | 15.2628 |
| 843 | 2.95 | 24.8685 |
| 225 | 6.44 | 14.49 |
| 598 | 3.62 | 21.6476 |
| 796 | 3.38 | 26.9048 |
| 986 | 2.5 | 24.65 |
| 604 | 1.9 | 11.476 |
| 595 | 3.09 | 18.3855 |
| 608 | 1.54 | 9.3632 |
| 551 | 5.73 | 31.5723 |
| 315 | 4.05 | 12.7575 |
| 476 | 3.37 | 16.0412 |
| 492 | 3.68 | 18.1056 |
| 637 | 4.07 | 25.9259 |
| 505 | 3.78 | 19.089 |
| 969 | 3.37 | 32.6553 |
| 642 | 3.72 | 23.8824 |
| 18711 | 500.8297 |
NOTE: the values in the percentage table need to be divided by 100 before multiplying by the amount. e.g. the first row would be = 374 × (-0.28/100) = -1.0472
We can now calculate our weighted average interest.
Weighted average interest = 500.8297 / 18711 = 0.0267.. or 2.67%
We have to manually calculate the tax rate as it is not directly given on the annual report. We take the income tax expense and divide it by the earnings before tax to arrive at the effective tax rate.
Tax rate = (1318 / 6711) × 100 = 19.64%
After tax cost of debt = 2.67 × (1 - 19.64/100) = 2.14%
The above calculations are an accurate way to calculate the cost of debt, however they rely on the debt details being listed in the annual report. As the list of debt types are not a part of the income statement, balance sheet or cash flows on the quarterly / annual report, you may not have that information. If this information is not available you can get a more general measure of cost of debt by using this formula:
Cost of debt = (risk free rate of return + credit spread) × (1 - tax rate)
The risk free rate, like its name suggests, is the interest rate an investor can get that has zero risk of default. The risk free rate is commonly set at the three-month treasury bill interest rate, for US companies, as government treasury bonds are seen as close to risk free as possible.
The average 3 month T Bill for December 2020 was 0.02%.
The credit spread is the difference between the government treasury bond rate and the rate at which the company in question can get for its bond. The more risk the company has of defaulting (not paying out the bond), the higher the yield expected from their bonds and then the higher the spread will be.
NOTE: Sometimes it is difficult to get the bond yield for a company, say if they are private for example. If you're unable to get the bond yield of a company you can estimate it by getting the credit rating of the company and using the bond yield of similar companies with the same rating.
The current coupon rate for a 3M bond maturing in 2022 is 2%.
Credit spreed = 2 - 0.02 = 1.98%
Cost of debt = (0.02 + 1.98) × (1 - 19.64/100) = 1.6%
We can see that we get two different results when calculating cost of debt. Calculating the cost of debt using the weighted average interest rate is more accurate than using the credit spread because we're using real data with the former. Wherever possible you should use the weighted average interest rate.
NOTE: We have tried to be as accurate as possible with this article, but there may be errors in the formulas used and/or the inputs.
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