Estimating a Company’s Pre-Tax Cost of Debt from Bond Prices

Summary

The note addresses how to estimate a company’s current pre-tax cost of debt when its outstanding bond trades above face value. The example gives a long-dated bond with a stated coupon, face value, and higher market price, and asks whether the coupon rate alone represents the company’s debt cost. The answer says the current cost is market determined, so the observed market value matters.

The proposed approach is to solve a time-value-of-money equation for the yield that equates the bond’s market price with its promised cash flows. This differs from simply using the coupon rate, which is based on face value and reflects the bond’s terms when issued. The answer also connects the premium price to accounting: the premium is amortized over the bond’s life, and the amortization relates coupon payments to interest expense at the market rate at issuance. The short exchange gives no numerical yield calculation or treatment of taxes, default risk, or changing rates, so it is an outline rather than a full valuation example.

Key ideas

• A bond’s coupon rate alone does not determine the issuer’s current cost of debt.
• The current market price is used to estimate the market required yield.
• Solve for the rate that equates the bond’s price with the present value of its cash flows.
• A bond premium is amortized over its remaining life in accounting.

Tags

# Calculating pre-tax cost of debt


# Calculating pre-tax cost of debt












This is a simple problem but I'm not sure about one aspect of it.

A company has 15 year bonds outstanding, with a 5% annual coupon, a face value of \$1000, and a current market value of \$1100. What is the company's pre-tax cost of debt?

I'm tempted to think it's just 5%, as when the company originally sold the bonds it received $1000 and is paying 5% coupons on that original face value, but the inclusion of the current market value is confusing me. I'd appreciate any help you can give me.

## Answer by jeff m (score 1, accepted)

https://quant.stackexchange.com/a/4710

It's a simple TVM problem - solve for the interest rate. The "current" cost of debt would be market determined, so that's why you use the market value. It ties into how bond accounting works - the premium of the bond is amortized until maturity. The amortization amount would be the difference between the coupon and the interest expense(market rate at issuance)

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.