Factors Affecting the Cost of Capital and the Cost of Debt

Top down (i.e., external or macro) factors include:

Capital availability. Economies with plentiful availability of capital will have lower cost of capital. Developed economies with established liquid capital markets tend to have more stable currency values and better investor protections via rule of law, and accordingly will have greater capital availability compared to developing economies.

In some less developed countries that lack corporate debt markets, businesses have to rely on bank lending or a shadow banking system of unregulated, non bank sources. Market conditions. Factors include inflation, interest rates, and the state of the economy.

Lower levels of expected inflation lead to lower nominal risk free rates. Risk premiums on both debt and equity shrink during economic expansions, and rise during economic contractions. The transparent and predictable monetary policies of developed economies tend to reduce risk premiums and interest rates.

Finally, countries with higher currency volatility will need to offer higher risk premiums to risk averse investors. Legal and regulatory considerations, country risk. Countries that follow common law based legal systems offer stronger protection to investors, leading to lower risk premiums compared to countries with civil law based legal systems.

Tax jurisdiction. Tax code affects the deductibility of interest expense on debt. All else equal, the higher the marginal tax rate, the greater the tax benefit of using debt in the capital structure.

Bottom up (i.e., company specific) factors that affect the cost of capital include:

Business or operating risk. Volatility in revenues, earnings, and cash flows is a measure of business risk. Businesses with stable revenues (e.g., utilities or subscription based services) have relatively stable earnings and cash flows, and are therefore less risky than businesses with more volatile revenues (e.g., cyclical industries).

Companies generating most of their revenues from only a few customers face customer concentration risk. Use of debt in the capital structure increases financial leverage, which increases the volatility of earnings and cash flows. Companies with poor corporate governance, as well as companies with high ESG related risk exposures, will see investors demand higher risk premiums.

Asset nature and liquidity. Company assets form the collateral for servicing debt in the event of a liquidation. Companies with tangible, non specialized (i.e., fungible) assets and more liquid assets would have a higher recovery rate and hence a lower risk premium.

Specialized assets and intangibles (e.g., goodwill, patents, proprietary production processes, etc.) do not have a ready liquid market, resulting in a lower recovery rate. Assets specifically designated as collateral reduce the cost of secured debt, but increase the cost of other subordinated unsecured debt as their claim becomes inferior. Financial strength and profitability.

Companies with higher profitability, higher ability to generate cash, and lower leverage, have a lower probability of default; therefore, investors will accept a lower risk premium. Leverage ratios such as debt to equity or debt to EBITDA are used by analysts.

Security features. Embedded call options make a security less desirable and increase the risk premium. While a callable bond increases the current cost of borrowing for the issuer, it does allow the company to refinance the debt at a favorable rate should interest rates decline in the future.

Conversely, a put option or conversion option reduces the cost of borrowing for the company, because a putable bond is issued at a favorable rate. However, the borrowing cost may increase in the future if investors put back the bond in a rising interest rate scenario and the company is forced to refinance at a higher rate. A cumulative preferred stock accumulates missed dividends when the company is unprofitable; such stock has a lower risk premium than equivalent non cumulative preferred stock.

Classes of common equity that have superior rights have a lower cost than those classes with inferior rights.

Estimated cost of debt is impacted by various factors, including whether the debt is publicly traded, whether it is rated by a ratings agency, and which currency the debt was issued in.

Publicly Traded Debt

If the company’s debt is publicly traded, the yield to maturity for the longest maturity straight debt outstanding is generally the best estimate of the cost of debt. However, if the longest maturity debt is thinly traded, and a shorter maturity debt with more reliable market price information is available, we may use the yield on this shorter maturity debt instead.

Non Traded/Thinly Traded

If the company’s debt is not traded or is thinly traded, we can use matrix pricing to consider the yields on traded securities with the same maturity and credit ratings. If the debt is not credit rated, then financial ratios of the company such as the interest coverage (IC) ratio or financial leverage (D/E) ratio may be used to infer a credit rating for that debt. It is also common to obtain credit spreads for specific ratings and add those to the benchmark rates to arrive at the cost of debt.

When using credit ratings, analysts should realize that an issuer rating may differ from the ratings of the issuer’s individual series of debt, depending on the seniority of the specific series and whether it is secured by a collateral.

Worked example: Cost of debt using matrix pricing

Brevis Solutions is a technology provider for the healthcare sector. Sunil Tilak, CFA is trying to estimate the cost of debt, which represents 30% of Brevis’ capital structure. The 6 year, BB rated debt is thinly traded.

Tilak collects data, shown here, on similar BB rated securities that have liquid markets.

Estimate the cost of debt using the matrix method.

Solution

First calculate the YTM of each of the four comparable securities.

Using your calculator, for Listor: PV = −114, N = 7, PMT = 8, FV = 100, CPT I/Y = 5.53%

We then construct a matrix of maturity and coupon rates as follows:

Maturity	Coupon rate 5%	Coupon rate 6%	Coupon rate 7%	Coupon rate 8%	Average
4	5.16%	5.50%	Not available	Not available	5.33%
7	Not available	Not available	5.26%	5.53%	5.39%

The average yields for each maturity are then calculated and used as estimates for those maturities.

Finally, we use linear interpolation to determine the YTM for a 6 year bond as follows:

In many countries, bank debt is the primary source of debt capital. Because we are interested in the marginal cost or the cost of a new bank loan, the rate on existing debt will not be a good estimate if the company’s characteristics or the general level of rates has changed.

Leases, and specifically, finance (i.e., capital) leases, can be used to estimate the cost of borrowing. The rate implicit in the lease (RIIL) is the implied cost of capital in a lease. RIIL is the IRR in the following equation:

PV of lease payments + PV of residual value = Fair value of leased asset + Lessor’s initial direct cost

Usually, the terms of a finance lease are disclosed. If they are not, then the incremental borrowing rate (IBR), the rate on a new secured loan over the same term, may be used.

International Considerations

For foreign borrowers, the cost of debt should include a country risk premium. A country risk rating (CRR) reflects risks related to economic conditions, political stability, exchange rate risk, and the level of capital market development. Country ratings can be similar in format to debt ratings (e.g., AA), or can be a numerical rating (e.g., 8).

A country may be assigned a rating relative to a benchmark country. The excess of the median interest rate for that country relative to the benchmark country rate determines the country risk premium. In Figure 15.1, Country A is the benchmark country, and hence that country’s risk premium is zero.

Country C’s median interest rate is 6.80% resulting in a country risk premium of 6.80% − 4.20% = 2.60%.

Figure 15.1: Country Risk Premium