IB Manual – Cost of Debt and WACC

The return that a company provides to its debt holders and creditors

Cost of Debt and WACC

The cost of debt is the return that a company provides to its debtholders and creditors. When debtholders invest in a company, they are setting an agreement wherein they are paid periodically, or on a fixed schedule. Bond agreements or indentures set up the schedule, the maturity date, call options if applicable, and any other relevant indentures. Bonds are a safer investment than stocks due to the payment schedule (interest payments will not go down during a bad year) but also produce smaller returns (interest payments will not go up during a good year). Due to the added security, required debt returns are lower than stock returns.

 

Cost of Debt

 

Cost of debt

Corporate bonds differ from Treasury bonds in the sense that they incur default risk. Default happens when a firm fails to pay an interest payment to a bondholder. No matter how financially stable a firm appears, default risk is always a possibility. Therefore, debt investors demand a return that includes a premium over the risk-free rate. The premium acts as compensation for the additional risk of default faced by a corporate lender. The size of the premium (default spread) will reflect the debt investors’ perception of default risk; the higher the risk, the higher is the demanded premium. Debt finance offers the advantage of being a cheaper source of financing relative to equity. It provides the additional benefit that interest payments are tax-deductible (tax shield).

 

Estimating the default risk spread

Debts of most publicly traded companies are not usually traded but are instead rated by rating agencies such as S&P, Moody’s and Fitch. Using these debt ratings and their associated published default risk spreads, the cost of debt can be estimated using an appropriate risk-free rate. Issues only arise for small or emerging companies whose debt is not rated. For these companies, default risk premium can be measured by:

  • Examining recent borrowing history; or
  • Estimating a synthetic rating (do the work of a rating agency and create a score).

Some of the formulas used by ratings agency to assess default risk include:

 

Formulas for Key Ratios

 

Once the default risk premium’s been estimated, it is added to an appropriate risk-free rate. It will yield a pre-tax cost of debt. However, the relevant cost of debt is the after-tax cost of debt, which comprises the interest rate times one minus the tax rate [rafter tax = (1 – tax rate) x rD].

 

Full cost of debt

Debt instruments are reflected on the balance sheet of the company and are easy to identify. However, the issue is with the definition of debt:

“A liability is an obligation resulting from a past transaction that leads to a probable future outflow of economic benefit.

Debt instruments are instruments issued as a means of raising finance other than those classified in/as shareholders funds.”

 

Are all financing obligations accounted for in the WACC calculation? The following are examples of liabilities that may be omitted from the WACC calculation because of accounting rules:

  • Operating leases
  • Special purpose vehicles
  • Joint ventures and associates
  • Net pension deficits

 

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a firm’s cost of funds. WACC is composed of the individual costs of capital for each provider of financing to the company, weighted by the relative size of their contribution to the pool of finance. To calculate WACC, one must consider:

  • If all the costs of finance been calculated
  • If WACC components should be weighted by book or market values

 

The formula for calculating WACC is as follows:

 

WACC Formula

 

WACC weighting – Book or market value weightings

Balance sheet items are valued historically; they are outdated but consistent with accounting rules. It is argued that book value removes volatility but are nevertheless non-representative of market conditions. Most firms use WACC at the market value weighting approach; however, there are several possibilities:

 

Weighting proportions

 

Current market value

  • This is empirically correct but the current position may be atypical and exposed to volatility

 

Optimum leverage ratio

  • Using either Modigliani & Miller or an empirical model, it is possible to derive the optimal capital structure for the firm’s WACC. Determining optimum leverage is merely a matter of finding the optimal capital structure that trades off tax benefits with the added financial distress of debt.

 

Target leverage ratio

  • Some firm’s board of directors may set an attainable leverage ratio and use this structure as their WACC weighting, even if they are not currently at that capital structure

 

Industry average

  • Some firms may use the average weights that company competitors use for WACC. However, events such as IPO lack available data. There is a belief that a company’s capital structure will tend towards an average.

 

Bottom-up

  • If the WACC is partly built from an unleveraged and releveraged cost of equity, the weighting used in the WACC model should be consistent with the weightings used when releveraging the unleveraged beta.

 

Additional resources

Thank you for reading this section of CFI’s free investment banking book on cost of debt and WACC. To keep learning and advancing your career, the following resources will be helpful:

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)™ by completing CFI’s online financial modeling classes and training program!