Cost of Debt Discussion

How do you determine the appropriate cost of debt for a company?  Does it make a difference if the company’s debt is privately placed as opposed to being publicly traded?  How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors?

Topic 4

What is financial leverage and what is it’s impact on stockholders? Is there an easily identifiable debt-equity ratio that will maximize the value of a firm (explain why or why not)?

Use the book Essentials of Corporate Finance, 10th EditionBy: Ross, Stephen A. / Modigliani, Franco / Westerfiel to reference the discussion and peer reviews.

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Topic 3

With the interest tax shield as a reference, I will figure out how much debt the company can afford by removing the whole market value of the loan and the costs of borrowing money to pay it. In order to calculate the cost of debt, these loans and the interest rates that the corporation would charge after adjusting for current market value are taken into account.

The cost of borrowing money is equal to the interest rate (1- tax).

If the company is listed on a stock exchange, we may simply use the market value of its debt; if it is not, we must use the book value of its debt. For businesses that only problem private sector debt securities to investment firms, the cost of debt must also be calculated after adjusting the debt capital in relation to other companies which have publicly issued those securities, so that a market price method that is sufficiently suited for such businesses and that will offer additional better adjustment can be applied to these companies. The after-tax cost of debt for a corporation to calculate is the interest rate it would have to pay if it were to issue new debt today. Because of this, the yield-to-maturity (YTM) on the firm’s existing bonds may be used to properly forecast the cost of debt for the company. A firm can estimate the cost of its debt by comparing its debt costs to those of other similar companies in similar risk classes, as well as by looking at the average cost of debt for other companies with a similar credit rating (assume that the firm in question has the same credit rating as this one), and by looking at the debt costs of other similar companies in the same risk class

References

Eliwa, Y., Aboud, A., & Saleh, A. (2021). ESG practices and the cost of debt: Evidence from EU countries. Critical Perspectives on Accounting, 79, 102097.

Gao, H., He, J., Li, Y., & Qu, Y. (2020). Family control and cost of debt: Evidence from China. Pacific-Basin Finance Journal, 60, 101286.

Sugiyanto, S., Febrianti, F. D., & Suripto, S. (2020). Good Corporate Governance And Tax Avoidance To Cost Of Debt With Growth Opportunityas Moderating (Empirical Study On Manufacturing Company And Finance Service Listed In Idx 2015-2019). The Accounting Journal Of Binaniaga, 5(2), 123-140.

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There are many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs that cannot easily be identified or quantified, thus making it practically impossible to determine the precise debt–equity ratio that maximizes the value of a firm. However, if a firm’s cost of new debt suddenly becomes much more expensive, it’s probably true that the firm is too highly leveraged.

From our reading this week, we learned that the more capital intensive industries, such as airlines, cable television, and electric utilities, tend to use greater financial leverage. Also, industries with less predictable future earnings, such as computers or drugs, tend to use less. Such industries also have a higher concentration of growth and startup firms. Overall, the general tendency is for firms with identifiable, tangible assets and relatively more predictable future earnings to use more debt financing. These are typically the firms with the greatest need for external financing and the greatest likelihood of benefiting from the interest tax shelter.

-Prof. Bernard