How do you estimate a company's cost of debt?

Use today's borrowing cost, not old coupons: the yield to maturity on traded bonds, or a rating-based spread over the risk-free rate. Then tax-effect it for WACC, so 5.75% becomes about 4.3% at a 25% tax rate.

The numbers, step by step

The rating approach from the answer, with an assumed 4% risk-free rate, a 1.75% spread and a 25% tax rate.

Pre-tax cost of debt4% + 1.75%

5.75%

After-tax cost of debt5.75% × (1 − 25%)

4.31%

What the interviewer listens for

• Do you say it's today's borrowing cost, not the coupon?
• Do you use yield to maturity for bonds that trade?
• Do you have a method when the debt doesn't trade?
• Do you tax-effect it for WACC?

Common mistakes

• Using the coupon on existing bonds as the cost of debt.
• Forgetting to tax-effect the cost of debt before it goes into WACC.
• Dividing interest expense by book debt, which blends old rates.
• Giving a company with losses a tax shield it can't use yet.

Likely follow-ups

• Can the cost of debt ever be above the cost of equity?It shouldn't be. Lenders rank ahead of shareholders, so if my inputs say otherwise something is off, often a stale beta or a distressed bond's yield.
• How do you treat a distressed bond's yield?Carefully. Its yield to maturity assumes full repayment, so it overstates the return lenders actually expect once default risk is counted.
• What if the company has several kinds of debt?I weight each one's cost by its market value, or use the cost that fits the long-term target structure.

More finance technicals

• What is the mid-year convention in a DCF, and what does it do to the value?
• Terminal value makes up most of your enterprise value. Is that a problem?
• A company with no debt, worth $10 billion with 100 million shares at $100, borrows $1 billion at 6% to pay a special dividend. What happens to its WACC, enterprise value, equity value and share price?
• Walk me through a DCF.
• What is WACC and how do you calculate it?

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