Cost of Debt

Investors in a company's debt are interested in getting a rate of return that is in line with the return offered on other interest-bearing instruments, which carry the same risk. This is called the cost of debt.

It is also essential to note the following: That is, the yield to redemption, or market yield, is the average pre-tax marginal rate of interest (kd) on a firm‟s debt, reflecting its current credit rating. For irredeemable debt this is determined as: kd = I/P0. For redeemable debt, the yield to redemption will be the internal rate of return of debt using the current market value of the debt and future cash flows.

The relationship between the price of redeemable bonds, the coupon rate and the yield to redemption: P = PVcoupon flows + PVface = {C/r x [1-1/(1+r)n]} + {F/(1+r)n}

Also note that: the longer the maturity of a bond, the greater the sensitivity of the bond to changes in interest rates; and, therefore the greater the change in price corresponding to a particular change in yield.

The average cost of debt can be calculated on the basis of the cost of each of the different elements, with appropriate value weighting. Short-term debt should be included as part of the overall debt burden of the firm. However, cash and securities which can be sold easily may be deducted to derive the net short-term debt burden. And,  the capitalised value of lease commitments may be added to the overall debt.