SPEAKER 1: Hi. Welcome back to finance for non finance professionals. This week, we're talking about the cost of capital, or what discount rates to use. And what we're going to talk about in this lesson, is estimating the cost of debt. So there's three basic ways to think about this. Of course, any rate of return is going to be the risk free rate, plus some risk premium. And so we need to think about how to put a risk premium on that debt. We can look at the historical cost of debt to figure out a risk premium. We can look at the current yield to maturity. But probably the most useful method is the third, going to be the ratings adjusted yield. Playing off of our previous lesson thinking about credit ratings and quality spreads. So let's go through them. The first, historical cost means, what did the company pay the last time it issued debt? If I issue get three years ago. When I was paying 4 and 1/2 percent, maybe that's a best guess for what I've got. Maybe I would pay 4 and 1/2 percent the next time I issued. So I look at the interest expense of I'm paying on my current outstanding debt. What's the coupon rate, or the interest rate, that I'm paying on my most recent bond issue. And I say, OK, that's going to be my cost of debt. That's an OK method, but it's not a great method for estimating the cost of debt. If I've got nothing else to go on, that's what I'll use. But that may not reflect current market rates. Prices change in markets, interest rates go up, the Fed comes out and does something, interest rates go up and down. Historical costs don't always reflect the going forward, or forecasting, of what my cost of debt might be. So that's something to be careful of. And you know, rates may have changed in the meantime. My credit worthiness may have changed in the meantime. So historical cost is an OK method for estimating the cost of debt, but not the best. We have to be cautious about doing it, and understand that we're looking backwards, we're not looking forward using historical cost. Probably the best thing to do is use the current yield to maturity. If I've got outstanding debt, and that that is traded on markets, that would be great. I could go and look at what investors are currently trading my debt at and see what the yield to maturity is, and that's what I would issue if I was going to issue debt today. Trouble is, that really only works if you've got current market prices for the debt, which is really only going to be relevant for large public companies. So if you're thinking about putting a cost of debt on General Electric, I could go look at General Electric bonds that are trading most days. See what the yield to maturity is, see what the interest rate is currently being discounted on General Electric's bonds, and that's what they would pay if they issued debt today. If I'd don't have large public companies, if I don't have good market prices on a firm's debt, what am I going to do? The other thing we could do is go back to our previous lesson and think about a ratings adjusted yield. I look at the credit rating, or the debt rating, of the credit score for the firm, and I think about just putting a premium on top of the treasury rate based on the credit rating of the firm. This is nice because I can use other firms as comparables. See, it's hard to compare one stock to another, because they all wiggle individually. But bond is a bond is a bond. I promise to pay you this rate at this point in the future. Well whether that's issued by General Electric or IBM, outside of minor variations in credit worthiness-- which is what the credit score is going to tell us. Within a credit score category, the bonds are pretty much interchangeable. So if I see the price on another bond from a different firm, I can use that comparable to sort of infer what I would pay if I was going to issue debt. And so the ratings adjusted yield is a really nice method for doing that. We're going to adjust the treasury rate by the credit spread, which we talked about our previous lesson. So let's do an example a ratings adjusted yield. What would be my cost of debt if I was going to issue 10 year maturity for A-rated firm. If my credit score rating was around single A. Could go right back to that table that we talked about in the previous lesson, where I've got treasury rates. So the 1-year Treasury rate was around 20 basis points. The 10-year was around 2%. And I've got here-- these are coming from other firms where I can see bonds trading over time. All other firms that are double A, they trade at what we call at 30 basis point premium. In other words, 65 basis point premium. I would take those basis points, 65-- that's .65%-- and add it to the treasury rate. If I were 10-year, A-rated firm-- I would take the 10 year column, and I would take the A-rated there. What's the intersection right here? That's that 147. I would add it to the treasury rate, and that would be my cost of debt. Using that 147, is coming from what other similar 10-year A-rated debt is trading at. All I need to know is that I'm roughly an A-rated firm. I'm issuing around 10-year maturity debt. All I do is I take the 2% treasury rate, add on 147 basis points, or 1.47%, and that gives me a cost of debt of 3.4%. A nice, simple easy back of the envelope way to calculate cost of debt. Much easier than the equity cost, which we had to calculate betas and covariances. Because equities are unique and move around and wiggle lot, that's a lot easier. I can just look at comps, figure out what quality spread, tack it onto the treasury, call it a day. OK, interest payments are tax deductible. It's important to remember this. The effective cost of debt is less than what I actually pay to the bank. In fact, our effective cost of debt is going to be 1 minus the tax rate, times whatever my nominal interest rate is. Let's walk through an example, I think it's easier to see. If you pay 5% on your debt, and you've got a 20% tax rate, you're going to make an interest payment of $5 to the bank for every $100 of debt. Your taxes, though, are going to go down. Because I get to subtract that $5 from the income statement, my taxes are going to go down by $1. So net, I'm really only paying $4. Because I'm paying $5 to the bank, but I get to collect a dollar back in taxes. My net's really only $4, my effective cost of debt is 4%, which is 5% times 1 minus 20, or 80% of 5% is 4%. To sum up, the cost of debt reflects the premium of default in recovery. We could use a historical cost of debt, the current yield-- if I've got some good market prices-- or I'm going to use the rating adjusted yield. Which is probably the most popular way to estimate the cost of debt. And always remember the interest is tax deductible. My effective interest rate is lower than what I'm actually paying.
