1. If company has publicly traded long-term investment-grade debt, cost of debt is determined using the yield to maturity.
2. If company has outstanding debt that doesn’t trade regularly, cost of debt is estimated using average yield of similarly rated debt.
3. If a rating does not exist for the company’s debt, estimate a synthetic rating and refer to #2.
4. If company has speculative-grade debt, cost of debt is calculated using the capital asset pricing model.
1. Yield to Maturity
If a firm has publicly traded debt, the pre-tax cost of borrowing is typically calculated by determining the yield to maturity (YTM) based on the current market value. Additional criteria, however, must be satisfied in order to employ this method. The debt must be long term (i.e. a maturity of at least 12 months), liquid (i.e. regularly traded), option-free (i.e. no special features like convertibility or callability), and investment grade (i.e. a rating of BBB or better). The yield to maturity is solved for by backing out the discount rate required to set the present value of the bond’s future cash flows equal to its current market price.
My preferred online resource for this information is Morningstar.com (here). Enter the ticker symbol of the company at the top of the page and then navigate to the bonds sub-heading. Note that the cost of borrowing (i.e. yield to maturity) should reflect the weighted average maturity of the firm’s debt.
2. Debt Rating Spread
For companies with illiquid or short-term bonds, the cost of debt can be estimated from its bond rating. Ratings are assigned by independent agencies, such as Standard and Poor’s or Moody’s, and are largely based on the financial ratios of the company. To indirectly measure the yield to maturity, determine the firm’s credit rating. Find other long-term bonds with the same credit rating and examine the yields typically paid by these firms.
A good data source for average corporate bond yields by debt rating is BondsOnline.com (here). Yields are expressed as a default spread over the 10-year treasury rate. It is also possible to calculate the term structure of interest rates (i.e. yield curve) by gathering data on similarly rate bonds, plotting the yields along the y-axis and the maturities along the x-axis, and determining the line of best fit (typically using a polynomial regression). Corporate bond data can be found using the bond screener at Yahoo Finance (here).
3. Synthetic Rating
If a firm does not have a credit rating for its long-term debt, the rating itself can be approximated by examining the default spreads paid by companies with similar financial characteristics. The most simplistic and effective metric to use is the interest coverage ratio, calculated as EBIT divided by interest expense. (If adjusting for capitalized operating leases, add back the rental expense to EBIT, subtract the implied depreciation from EBIT, and add the implied interest to interest expense). Aswath Damodaran provides a helpful table online (last updated in 1998) for estimating synthetic ratings based on interest coverage ratios (here). Otherwise, you can look for publications from the rating agencies themselves on the distribution of common financial ratios by rating, such as this one published in 2006 by Moody’s (here). Once a firm’s synthetic credit rating is assessed, it can be used to estimate its default spread.
4. Capital Asset Pricing Model
For companies with high-yield speculative-grade debt (i.e. a rating less than BBB), the yield to maturity is a poor estimator for the cost of debt. A better proxy is assessed by using the capital asset pricing model (CAPM). (For a tutorial on calculating CAPM betas, redirect to here). Rather than using the returns on the selected stock to generate a beta, bond indexes of different rating classes are regressed against the market portfolio (e.g. S&P 500 index). Bond indexes, rather than individual bonds, are used since the former trade more regularly than the latter.
You will need to determine the beta on an investment-grade corporate debt index (e.g. SP5IGBIT) as well as a high-yield corporate debt index (e.g. SP5HYBIT). At the time of writing this (1/4/2016), the beta on investment-grade bonds was -0.12 and the beta on high-yield bonds was 0.05 (returns were calculated using monthly intervals over 10 years). High-yield bonds therefore had a beta 0.17 higher than investment-grade bonds. The cost of debt is estimated as the spread in betas multiplied by the equity risk premium plus the current yield to maturity on BBB-rated debt. Assuming a 5% equity risk premium, a 10-year BBB default spread of 2.53%, and a 10-year treasury yield of 2.27%, the cost of debt estimate is equal to 5.65% [=2.27% + 2.53% + (0.17 * 5%)]. This approach will generally yield lower debt costs than those estimate using more conventional methods.
In practice it is often common to approximate a firm’s cost of debt by taking the current year’s reported interest expense divided by the average balance sheet value of short- and long-term debt. Some practitioners will even base their calculations on net interest and net debt (see formula below). While this method is easy to apply and often yields a reasonable estimate, it runs the risk of confusing past costs with the future anticipated cost of debt. It is therefore advisable to follow the methods outlined above in determining a firm’s marginal cost of borrowing.
Aswath Damodaran. Estimating Risk Parameters and Costs of Financing.
McKinsey & Company Inc., Tim Koller, Marc Goedhart, David Wessels. Valuation: Measuring and Managing the Value of Companies. (p. 327).