Cost of Capital: Cost of Debt Estimated by Yield
Suppose you are running a small business, and need to borrow some money for 10 years. A lender will want to be paid some rate of return. Suppose that for each 100 you borrow, you have to pay an annual coupon of 5, and then you'll pay back the 100 in 10 years. That's a 5% return each year for the lender.
What would you consider your cost of borrowing that money?
That's right!
The return to the lender is the cost to you of borrowing. Here, you'd start with that 5% as being part of how you could calculate your __cost of debt__. You're essentially issuing a 5% coupon bond at par here.
No, that's just a return of capital, but not really a cost to you.
No, not all payments would really represent a cost here.
But now suppose that you and the lender agree to skip that coupon altogether. For each 100 face value bond you issue (again, meaning borrowing), the lender will just give you 60 today in cash, and wait for 10 years to get the payment of 100. Without that coupon, would you still have a cost of debt?
Actually, you do. Taking 61 and paying back 100 should certainly look like a cost.
That's not it. Try to calculate the discount rate that equates these two numbers through time.
Absolutely.
This is just a discount bond, and you can calculate the yield that allows these two numbers to equate through time:
$$\displaystyle 60 = \frac{100}{(1 + r)^{10}}$$
The discount rate here is the yield of the discount bond, which is
$$\displaystyle r = \left( \frac{100}{60} \right)^{1/10} - 1 \approx 5.24 \%$$
Thinking at the margin, what do you expect would happen to your cost of debt in two years if your business had some problems and became riskier?
No, that wouldn't really make sense.
No, the cost of debt would be affected. Think about what would happen if you needed to borrow just a bit more at that point.
Absolutely.
With higher risk, your bonds would be worth a little less, and the yield would be a little more. Sure, the current bond agreement doesn't change, cost of capital estimations are always made at the margin, so that you're comparing the incremental cost of borrowing today with whatever new project or use is being considered.
To summarize this discussion:
[[summary]]
All payments made to the lender
The 100 paid back at the end
That 5% return
No
Yes, but it's lower
Yes, but it's higher
Nothing
It would fall
It would increase
Continue
