Cost of Debt

Hi, guys!

Who could explain me (a rookie who has no finance or any business-related background) the following paras more thoroughly and with simple words:

Professor’s Note: It is important that you realize that the cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. CFA Institute may provide you with both rates, and you need to select the current market rate. If a market YTM is not available because the firm’s debt is not publicly traded, the analyst may use the rating and maturity of the firm’s existing debt to estimate the before-tax cost of debt. If, for example, the firm’s debt carries a single-A rating and has an average maturity of 15 years, the analyst can use the yield curve for single-A rated debt to determine the current market rate for debt with a 15-year maturity. This approach is an example of matrix pricing or valuing a bond based on the yields of comparable bonds. If any characteristics of the firm’s anticipated debt would affect the yield (e.g., covenants or seniority), the analyst should make the appropriate adjustment to his estimated before-tax cost of debt. For firms that primarily employ floating-rate debt, the analyst should estimate the longer-term cost of the firm’s debt using the current yield curve (term structure) for debt of the appropriate rating category?

Thank you in advance and have a productive day!



Cost of debt = the interest that a firm has to pay in order to borrow = the interest rate it will pay on bonds issued

If you are trying to work out what the correct cost of debt is, look for the YTM on a newly issued debt by the firm as your before tax cost of debt

If a new issue isn’t available, you can use matrix pricing (i will let you Google the exact meaning of that) :slight_smile: but simply put, you look at the most recent debt issued by the firm, and look at the yield curve for an equivalent bond and use that YTM

If you have reason to think that there will be a change in the YTM, due to covenants or seniority of the bond (contractual agreements to lender) then you should account for that in your analysis i.e don’t ignore it

Hope this helps