Hi guys, I have encountered some difficulties in calculating cost of debt. I got one client who is private co, they’ve obtained a long term loan without any interest imposed. How to calculate the cost of debt if interest rate is 0%. What source should I refer to?
In calculating the cost of debt, you almost always want to figure out the marginal cost of debt – meaning, in plain language, what would the cost of debt be for the firm if they had to borrow more money tomorrow? The historical interest rate that they are paying on debt already assumed is not considered, because in determining the long-run financial viability of projects on the horizon, all the firm should consider is the cost of long-term debt financing. I am assuming that the client does not have a limitless zero-interest-rate lending source that would provide additional debt financing tomorrow if the firm needed it…how much would it cost them to borrow additional money?
Not sure what industry your client is in, if it is private equity, etc., but you may want to see if you can find an industry average or what similar firms are getting for debt financing rates. If not, another option is to use a pure-play publicly-traded comparable based on average industry credit quality, and then apply some illiquidity premium to it.
Check out Bank of America’s Merrill Lynch debt indicies to get a sense for what yields are in your industry. Also, was the company’s debt issued at a discount to face? If so, there is an implied interest rate that you can solve for. Were there any sweeteners like warrants or a conversion feature and/or was the debt issued in connection with an equity investment?
If anyone else here is handing out free zero-interest loans, sign me up.
I was about to say . . . .
Be careful, 0% interest rates almost always have up-front fees that amortize into a regular interest rate. They’re actually more damaging than an equivalent interest rate since if you pre-pay, you’ve still been on the hook for them.
Of course, you can decide that the amortized interest rate is worth paying if the use of debt is profitable enough - it’s just a mistake to forget that it’s there.
borrow at 0% as much as you can possible can. Invest in risk free treasuries. hold to maturity. pay back borrowed money.
riskless $. drink to celebrate.
If the environment is deflationary enough, you can get 0% nominal.