LOS C requires us to:

##### calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach

The cost of debt can be calculated using any of the following approaches:

# 1. Yield-to-Maturity Approach

a. Yield-to-Maturity (YTM) represents the annual yield an investor earns on a bond if it is held to maturity.

b. If the bonds are ** issued at par**, its YTM equals the coupon payments.

c. However, if the bonds are ** issued at premium/discount**, its YTM (or cost of debt) is lower/higher than the coupon payments, respectively.

d. For example, suppose we have $ 100, 10%, 10-year, semi-annual bonds issued at a market price of $ 110. The actual cost of capital would be calculated as follows:

Insert the following data in the financial calculator:

Particulars |
Value |

FV |
100 |

PMT |
5 (since 10% coupon is paid semi-annually) |

N |
20 (because of two payments each year for 10 years) |

PV |
-110 |

After putting this data, we need to compute the interest rate (**CPT I/Y**).

We get the interest rate as:

i = 4.2479% or 0.042479

To convert this into annual rate, we do the following:

r_{d }= (1+i)^{2} – 1

= (1+0.42479)^{2}-1

= 0.086763 or **8.6763**%

If, however, the rate of tax is 40%, the after-tax cost of capital would be:

= r_{d} *(1-t)

= 0.086763*(1-0.40)

= 0.052058 or **5.2058**%.

# 2. Debt Rating Approach

a. The best way to calculate the yield on a bond is through the YTM approach, using the market prices of the bond. If, however, the market price of the bond is not available. We can calculate the yield on the bond by using the debt rating method.

b. Here, based on the company’s debt rating, we use the yield on the comparably rated bonds in the market for calculating the cost of the debt.

c. Here, the pricing is done based on valuation relevant characteristics, such as market rates, returns, risks, seniority of the bonds, etc. It is also known as evaluated pricing or **matrix pricing**.

d. Other ** issues **that need to be considered before using such an approach are:

i. whether the interest rates are fixed or floating (the companies need to make the relevant adjustment for floating rates),

ii. debt with embedded options,

iii. non-rated debt,

iv. leases (these should be included in the cost of capital), etc.

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