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How to Calculate a Company’s Cost of Debt

In addition to owner’s equity, debt is one of the company’s sources of capital.

A company’s debt can be in the form of debt to the bank, or in the form of debentures sold to the capital market (corporate bond).

Every source of capital certainly requires a cost. In the capital structure of the company, debt is the capital with the lowest cost, because debt is tax deductible

Cost of Debt is the cost (in this case is interest) that must be borne by the company as a consequence of debt.

Quoting Aswath Damodaran, to calculate or estimate the cost of debt of a company, can be done in the following ways: 

  • If the Company has a traded outstanding straight bond, then the cost of debt can be calculated from the yield to maturity (YTM) of the bond.
  • If the Company has a credit-rating from a credit rating agency, then the cost of debt can be calculated from the default spread of the rating against Risk Free (a risk-free investment, usually using the reference rate of government bonds).  
  • What about a company that doesn’t have a credit-rating? :
    • If the company has just made a long-term loan to a bank, then the cost of debt can be estimated from the interest rate of the loan, or
    • The cost of debt can be calculated using the approach of a synthetic rating, obtained from the company’s debt ratios.

Note: for the valuation of company shares, the cost of debt must be calculated in the same currency as the cost of equity and cash flows of the company..

Before I describe the details of how to calculate the cost of debt, we first discuss at a glance what is a corporate bond and the relationship between before-tax cost of debt vs after-tax cost of debt.

Let’s start

 

Corporate Bond

Bond is a transferable medium-long-term debenture, which contains a promise from the issuing party to pay interest in a certain period, and pay off the principal of the debt at a predetermined time to the buyer.

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We need to know some of the terms that are characteristic of bond as follows:

  • Face value or Par Value is the principal value that will be received by bondholders at the time of maturity date.
  • Coupon (interest rate) is the interest value that bondholders receive periodically (e.g. 1 month, 3 months or 6 months). This coupon is expressed in annual percentage.
  • Maturity date is the date on which the bondholder will regain the principal of the debt or face value of the bond he owns.
  • Credit-rating is a standardized assessment of a bond issuer’s ability to repay its debt. This value is issued by the Rating Agency to give investors an idea of the level of risk from the bond.

There are different types of bonds :

  • Reviewed from the issuer side there are : government bonds (issued by the Government) and corporate bonds (issued by the company).
  • Reviewed from the interest payment system there are : zero coupon bonds (interest and principal of debt paid at once upon maturity date), fixed coupon bond (fixed interest rate), floating coupon bonds(floating interest rate / associated to certain benchmarks).
  • Judging from the exchange rights feature / option there are : convertible bonds (bonds can be exchanged into share ownership of the issuing company), exchangeable bonds (bonds can be exchanged to the issuing affiliate company), callable bonds (giving the issuer / issuer the right to buy back bonds at a certain price) and puttable bonds (requiring the issuer to buy back the bonds at a certain price throughout the life of the bond)

In relation to the cost of debt of the company, we will focus on Corporate Bond which is with the Type Straight Bond. This is the simplest type bond, without special features, with fixed coupons paid regularly at predetermined intervals and principal (face value) paid at maturity date.

This corporate bond is one of the company’s sources of capital to finance the company’s investment, operations and/or business development.

Corporate bond data in Indonesia can be seen on the official website “PT Bursa Efek Indonesia” (https://idx.co.id) or the official website “Indonesian Central Securities Depository” -KSEI (https://www.ksei.co.id) or the website “Penilai Harga Efek Indonesia” -PHEI (http://www.ibpa.co.id)

Here I quote some of the corporate bond data on the KSEI web:

Example of Corporate Bond Data in Indonesia
Example of Corporate Bond Data in Indonesia
Source : www.ksei.co.id

Before tax cost of debt vs After tax cost of debt

In the Income Statement structure, cost of debt (interest expense) is located before net profit before taxes, this means that this cost component is tax deductable.

To get the value after tax cost of debt, then the value before tax cost of debt needs to be multiplied by 1 reduced tax rate (corporate income tax).

Here’s the formula for after-tax cost of debt:

after-tax cost of debt formula

As explained earlier, because of its nature as a tax deduction, in the capital structure of a Company, long-term debt is the cheapest source of financing for a company, compared to other sources of capital such as preferred stock or common stock equity.

But of course there is a certain limit for a company to optimize its financial leverage (the use of debt to add assets), among others, in terms of the company’s Debt Ratios.

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For more details about this, please read my previous article:

OK, now let’s discuss in detail one by one how to calculate the cost of debt:

 

1. Calculating the Cost of Debt from Yield To Maturity (YTM) Corporate Bond

Yield to maturity (YTM) is the total yield of a bond consisting of interest and capital gains earned by an investor when holding the bond until maturity.

In the case of corporate bond, for the Company that issued the bond, this means the total cost incurred related to the bond, which consists of interest costs and emission costs (floatation costs).

Flotation cost (emissions cost or issuance fee) of a bond consists of underwriting costs and administrative costs.

Underwriting cost is the cost to underwriters.In Indonesia these underwriters include Indo Premier Sekuritas, Mandiri Sekuritas, Danareksa Sekuritas, Trimegah Sekuritas, BCA Sekuritas etc.

The amount of the cost for underwriting costs usually ranges from 1-3% of the value of bonds issued.

To calculate the yield to maturity of a bond from the Company’s side, we need to know the net proceeds value of the bond. 

Net Proceeds is the net value received by the Company from the issuance of corporate bonds.

For example, a company issues a total bond worth Rp 1 Trillion, with the condition of purchasing at least Rp 100 million.

Rp 100 million can be called face value or par value. If floatation cost (underwriting plus administrative cost) is 2%, then the net proceeds of this bond is Rp 98 Million for each nominal or the total money received by the Company is Rp 980 Billion.

That’s if the bond can be sold at its face value. If, for example the bond is sold at a price of 99% of its face value (so at a price of Rp 99 Million), then the net proceeds are Rp 97 Million for each face value, or the total money received by the company amounted to Rp 970 Billion Rupiah.

Furthermore, to calculate YTM, we also need to know the interest rate given (coupon) and tenor or bond duration (years to maturity).

To be clearer, let’s look at the example of yield to maturity bond calculations from the company side as follows:

Company X issues a total corporate bond worth Rp 1 Trillion, Minimum purchase requirement (Par Value) of Rp 100 million with a period of 5 years and coupon of 10%Flotation cost 2 %. Bond sold at par value (100%). What is the YTM value of the Bond issuance?

To calculate this YTM we can use two ways, first using formulas in Microsoft Excel spreadsheets, second using the formula approach..

The first way to use Excel is as follows:

Example of Yield to Maturity (YTM) Calculation for Cost of Debt
Example of Yield to Maturity (YTM) Calculation for Cost of Debt

As we can see in the calculation above, the yield to maturity (YTM) that becomes the before-tax cost of debt in this case is 10.53%.

 

The second way uses the approach with the formula YTM as follows:

approximate YTM Formula

We enter the data in the formula above, then approximate YTM = 

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{Rp 10,000,000 + (Rp 100,000,000 – Rp 98,000,000)} / {(Rp 100,000,000 + Rp 98,000,000) / 2 } = 10.51%

This second way is only an approach and not as accurate as the first way.

The value of YTM obtained (either by the first or second way) is the value of before-tax cost of debt.  

To get the after-tax cost of debt we need to multiply it by 1 minus tax rate as described earlier.

So the after-tax value of company X’s after-tax cost is: 10.53 % x (1-0.25) = 7.90 %

 

2. Estimated Cost of Debt from Company Credit Rating

If the company has not issued a corporate bond, or there has been a change in the Company’s credit-rating from the time the company’s bond was issued, then another way to estimate the Company’s Cost of Debt is from the company’s latest credit-rating.

Credit rating is a standardized assessment of a country’s or company’s ability to pay its debts.

These credit-ratings are issued by Rating Companies, such as Fitch Ratings, Moody’s Investor Service, Standard & Poor’s, for the world level. In Indonesia there are PT Pefindo (“Pemeringkat Efek Indonesia“) and PT Fitch Rating Indonesia.

Rating consists of two parts, namely the rating value itself (assessment of debt repayment capability based on the company’s current situation) and Outlook (the view of the rating of the assessed company will rise, remain or decrease in the following valuation period)

The following I quote from the official website of the Indonesia Financial Services Authority / “Otoritas Jasa Keuangan“- OJK (https://ojk.go.id) list of Rating Agencies and ratings recognized by OJK:

Rating Agencies and Ratings Recognized by OJK (Indonesian financial services authority)
Rating Agencies and Ratings Recognized by OJK (Indonesian financial services authority)
Source : www.ojk.go.id

If the company is going to issue a corporate bond or make a long-term loan to a bank, this credit-rating will affect the coupon or interest rate of the company. 

The better the credit-rating of a company, the lower the interest rate / coupon bond and vice versa.

This is in line with the principle of investment where the risk is straight with expected return. Companies with low credit-ratings should offer higher coupons as compensation for the large risks investors face in buying the company’s bonds.

As an illustration, here is the meaning of each grade credit-rating, which I summarized from Fitch Rating :

Credit Rating Definition by Fitch Rating
Credit Rating Definition by Fitch Rating
Source : www.fitchratings.com

Credit-rating of a company can be seen from the company’s official website and or the rating company’s website.

Here is an example of information about the Company’s credit-rating on Pefindo’s official website (https://www.pefindo.com)

Examples of Company Credit rating information available on the Rating Agency website
Credit Rating of PT ANTAM Tbk at Pefindo Rating Agency
Source : www.pefindo.com March 7th, 2021

 

Credit rating Telkom Pefindo 2020
Credit Rating of PT TELKOM, Tbk at Pefindo Rating Agency
Source : www.pefindo.com March 7th, 2021

Disclaimer: The selection of ANTAM and TELKOM as examples of company credit rating information that can be obtained on the website of the Rating Agency (Pefindo) in this article is only random.

A company’s credit-rating is related to the spread (the difference between risk free and the expected reasonable interest rate or return of the company’s bonds)

We can obtain risk free interest rate data (government bonds) and credit spread matrix from the official website of “Penilai Harga Efek Indonesia“-PHEI (http://www.ibpa.co.id)

Here is the table of interest rate government bonds (as a reference risk free) and credit spread matrix Indonesian Corporate Bonds that I quoted from the website in March 2021.

Risk Free (yield of Government Bond)
Risk Free (yield of Government Bond)
Source : www.ibpa.co.id.com March 5th, 2021

 

Credit Spread Matrix Indonesia
Credit Spread Matrix Indonesia
Source : www.ibpa.comMarch 1st, 2021

From the first table above, we get that risk free with the reference of 10-year tenor government bonds is 6.7855 %

To be clear, let’s look at the two examples below, for the determination of the cost of debt from the Company’s credit-rating:

First example: suppose a company X, obtains a AAA credit rating, 

then for corporate bond tenor 10 years from the second table above we get the credit-spread is 158.01 bps or 1.5801%. 

So that the reasonable return rate of corporate bonds is 6.7855% + 1.5801 % = 8.3656 %, or 8.37 %.

This is the before-tax cost of debt from company X. 

To get after-tax cost of debt we multiply by (1 reduced tax rate), which is 8.37% x (1-0.25) = 6.27 %

 

Second example: suppose a company Y obtains a BBB credit rating, 

Then from the table above we get the credit-spread is 618.70 bps or 6.1870%. 

So that the reasonable return rate of corporate bonds is 6.7855% + 6.1870 % = 12.9725%, or 12.97%.

This is the before-tax cost of debt from company Y. 

To get after-tax cost of debt we multiply by 1 reduced tax rate, which is 12.97% x (1-0.25) = 9.73 %

From these two examples we can conclude that the higher the credit-rating of a company, the risk (default) of the company is smaller, then the cost of debt will certainly be smaller, and vice versa.  

 

3. Estimated Cost of Debt with Synthetic Credit-Rating

If the Company does not have a credit-rating from the Rating Agency, then there are two approaches that can be used to estimate its cost-of-debt:

  • If the company has just made a long-term loan to a bank, then the cost of debt can be estimated from the interest rate of the loan, or
  • The cost of debt can be estimated using a synthetic rating of the Company.

According to Damodaran, a company’s credit-rating can be estimated from the company’s Interest Coverage Ratio (EBIT/ Interest Expense). This estimate rating is called synthetic rating.

Interest_coverage_ratio

With this synthetic rating, we seem to act as a rating agency to determine the credit-rating of a company. 

It should be emphasized that this is only an approach that simplifies rating assessment based on only one company financial ratio (interest coverage ratio).

Official Rating Companies (such as Fitch Ratings, Standard & Poor’s or PT Pefindo) certainly have a more complex methodology in determining a company’s credit-rating.

Quoted from Damodaran Online (https://pages.stern.nyu.edu), here is an example of interest coverage ratio and rating table  

Damodaran synthetic rating
Damodaran synthetic rating
Source : Damodaran Online modified

Aswath Damodaran did the calculations to produce the synthetic-rating table from the company’s data in America from 1999 to 2000, by collecting data on companies that already have credit-ratings from rating agencies, then analyzing the interest coverage ratio and coupons of corporate bonds issued by the company.

If you want to be used in Indonesia with the current conditions, of course the table needs to be adjusted. 

As Damodaran does, if you want to create an Indonesian version of the synthetic rating table for current conditions, you need to analyse the data of companies that already have a credit-rating from the rating agency, then associate it with the interest coverage ratio and coupon of the company’s bond issued (or use credit spread matrix from the “Penilai Harga Efek Indonesia”) so as to produce a rating table like the example above. 

 

Summary

Thus an explanation of how to calculate the cost of debt of the Company. Furthermore, this cost of debt, has further benefits because it is part of the Weighted Average Cost of Capital (WACC).

This WACC is a weighted average of a company’s capital costs that is very beneficial in determining the investment decisions and valuation of company shares.

Read also my article that explains the cost of equity (other components forming WACC), WACC calculations and Stock Valuation :

 

If you have any questions, or suggestions, feel free to address them in the comments section below.

 

Source :

This post is also available in: Indonesian

Daniel
Danielhttps://danieel.id
Lahir di Palembang pada bulan November 1981, saya menyelesaikan S1 di Jurusan Teknik Kimia Universitas Sriwijaya, dan S2 Master of Business Administration (MBA) di Sekolah Bisnis Management Institut Teknologi Bandung (SBM-ITB). Bekerja di salah satu BUMN dan tinggal di daerah Jakarta Selatan.

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