STEP 10 – WACC - CALCULATE COST OF DEBT

You can’t just go to a company’s annual report and capture their cost of debt for use in your WACC calculation. The
cost of debt in the annual report is historical and may not reflect your choice of debt – equity mix in your WACC or
the cost of debt in the future. You must find the company’s future cost of debt for the credit rating implied by the
debt-equity mix in your WACC.

METHOD 1: YIELD TO MATURITY APPROACH (ONLY FOR PUBLIC DEBT)

Determine the Weighted average of current yields to maturity on all issues in the target capital structure. The yield
to maturity incorporates the market’s expectations of future returns on debt and should be used instead of the
coupon rate

METHOD 2: CREDIT RATING APPROACH

First determine the credit rating the company would have been given your assumed debt-equity mix. S&P,
Moody’s and other credit rating services publish ratio guidelines for different credit ratings. The rating guideline
change frequently, so check for the latest information. Once you have the credit rating, check Bloomberg for yield
to maturity on publicly traded long term bonds with the same credit rating.

Cost of Debt = Risk Free Rate + Spread

The difference between company’s cost of debt and the benchmark rate (LIBOR/Government Bond) is called a
Spread

METHOD 3: SYNTHETIC RATING METHOD

If the company bonds are not listed, then one must calculate the implied synthetic default spread.

Cost of Debt = Risk Free Rate + Synthetic Default Spread

Calculation of Synthetic Default Spread

 Calculate the interest coverage ratio = EBIT / Interest Expense.

 Derive the Synthetic default spread as per the table below.

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 High Market Cap firms Low Market Cap Firms
Interest Interest
Coverage Ratio Rating Spread Coverage Ratio Rating Spread
> 8.5 AAA 0.75% > 12.50 AAA 0.75%
6.50 -8.50 AA 1.00% 9.50 - 12.50 AA 1.00%
5.50 - 6.50 A+ 1.50% 7.50 - 9.50 A+ 1.50%
4.25 - 5.50 A 1.80% 6.00 - 7.50 A 1.80%
3.00 - 4.25 A- 2.00% 4.50 - 6.00 A- 2.00%
2.50 -3.00 BBB 2.25% 3.50 - 4.50 BBB 2.25%
2.00 - 2.50 BB 3.50% 3.00 - 3.50 BB 3.50%
1.75 - 2.00 B+ 4.75% 2.50 - 3.00 B+ 4.75%
1.50 - 1.75 B 6.50% 2.00 - 2.50 B 6.50%
1.25 - 1.50 B- 8.00% 1.50 - 2.00 B- 8.00%
0.80 - 1.25 CCC 10.00% 1.25 - 1.50 CCC 10.00%
0.65 - 0.80 CC 11.50% 0.80 - 1.25 CC 11.50%
0.20 - 0.65 C 12.70% 0.50 - 0.80 C 12.70%
< 0.20 D 14.00% < 0.50 D 14.00%

Note – This is just a guideline table. However, you should check with your senior for the revised updated table.

METHOD 4: COMPANY REPORT METHOD (SPOT CHECK!)

From the Annual report / quarterly report find interest rate applicable on each debt. The cost of debt may be
historical but it may provide a good double check.

Interest Expense
Cost of Debt =
Average Debt

COST OF DEBT CALCULATION FOR COMPANY ABC

Using synthetic rating method, we have Interest coverage ratio = EBIT / Interest Expense

Interest Expense for ABC company (small cap $257million) is 15; Interest coverage ratio = 50/15 = 3.33

High Market Cap firms Low Market Cap Firms

Interest Interest
Coverage Ratio Rating Spread Coverage Ratio Rating Spread
> 8.5 AAA 0.75% > 12.50 AAA 0.75%
6.50 -8.50 AA 1.00% 9.50 - 12.50 AA 1.00%
5.50 - 6.50 A+ 1.50% 7.50 - 9.50 A+ 1.50%
4.25 - 5.50 A 1.80% 6.00 - 7.50 A 1.80%
3.00 - 4.25 A- 2.00% 4.50 - 6.00 A- 2.00% Default spread for ABC company is
Excel Beyond Excellence!

2.50 -3.00 BBB 2.25% 3.50 - 4.50 BBB 2.25% 3.50%

2.00 - 2.50 BB 3.50% 3.00 - 3.50 BB 3.50%
1.75 - 2.00 B+ 4.75% 2.50 - 3.00 B+ 4.75%
1.50 - 1.75 B 6.50% 2.00 - 2.50 B 6.50%
1.25 - 1.50 B- 8.00% 1.50 - 2.00 B- 8.00%
0.80 - 1.25 CCC 10.00% 1.25 - 1.50 CCC 10.00%
0.65 - 0.80 CC 11.50% 0.80 - 1.25 CC 11.50%
0.20 - 0.65 C 12.70% 0.50 - 0.80 C 12.70%
< 0.20 D 14.00% < 0.50 D 14.00%

Pre tax Cost of Debt = Risk Free rate + default spread = 5.0% + 3.50% = 8.50%

Post tax cost of debt = 8.50% x (1-33%) = 5.70%

Note – we have assumed Risk Free Rate to be 5.0%.(please see the detailed note below on risk free rate)

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