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M&A Fundamentals – Calculating the Cost of Debt for the WACC Formula

The cost of debt (“Kd”) is one component of the working average cost of capital (“WACC”) formula used by M&A professionals to calculate the discount rate they will use to value an M&A target using a DCF present value model.

We explain the WACC calculation in another article in this M& Fundamentals series – M&A Fundaments – Working Average Cost of Capital (WACC).

Large corporations have complex financial structures and will use a variety of equity, debt, and hybrid securities to raise the funds invested in their operations.   Debt, whether corporate bonds traded on an exchange, or loans provided by banks or similar institutions, is attractive to companies that want to raise finance without giving up ownership.  It has the added benefit that interest payments are deductible against tax (often referred to in M&A circles as the “tax shield”).

We explore the different types of debt companies use to raise finance in another article in this M&A Fundamentals series:  M&A Fundamentals – Understanding the Role of Debt and Equity in M&A Transactions.



Calculating the Cost of Debt


Although a corporation may have several classes of stock in its equity structure, it is in the debt portion of the balance sheet that we are most likely to find a wide range of financial instruments.   Most M&A professionals would be delighted, and somewhat surprised, to find an M&A target with just one type of debt in its balance sheet.  In practice the cost of debt used in the WACC formula is likely to be a weighted average of the interest rates on several different forms of debt.

It is beyond the scope of this article to review the cost of capital calculation for every form of debt. Lengthy, and invariably tedious, books have been written on this very subject.  This article will look at some of the most common forms of debt you might find in either your own, or the M&A target company’s balance sheet.


The Tax Shield

Before we get to specific forms of debt, let us examine of one of the most important aspects of debt finance, the tax shield.  The cost of debt to the borrower is reduced by the company’s ability to relieve interest costs (but not capital repayments) against tax.  To this extent the cost of debt can be framed simply as interest on debt net of tax relief.  This is expressed in the following formula:



It is the after-tax relief cost of debt that is used by M&A professionals in the WACC calculation.



The formula for this type of debt instrument is:



The important thing to note is that for this type of traded bond Kd varies with the traded price of the bond.

As an example, let us take a corporate bond with a face value of $100 and a 5% coupon trading at $95 on the exchange.  If corporate income taxes are 20% the bond will have a Kd of (5% x 0.8 = 4%) / (95/100) = 5.26%.



A quoted redeemable bond would be valued on its redemption yield.  The redemption yield is the IRR of the after-tax cash flows to redemption.



Variable rate bank loans are usually overdrafts or near equivalents such as invoice finance.  Kd for this type of debt can be calculated using the standard tax shield formula.



Kd for a fixed rate bank loan could be calculated using the standard tax shield formula, but best practice is to find the after-tax yield of a comparable corporate bond issued by a company with a similar risk profile.



Although technically a form of equity preference shares with a fixed dividends and preferential security are treated like debt in the WACC formula.   The cost of capital formula for this type of security is:



The most important thing to note is that because preference shares are paid out of after tax profit there is no tax shield.






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