Question

If the company’s bond are publicly trading, how would you compute the pre-tax cost of debt? Explain first assuming that there is low chance of default and then assuming there is a high chance of default and hence expected loss.

Answer 1

Cost of Debt which is the borrowing cost is usually adjusted for tax,

Suppose you borrow $10000 at 10% and tax is 35% then the adjusted rate of interest is 10%(1-0.35)=6.5%,

On a Pre-tax basis you will not the benefit of adjusting taxes in your books and your interest cost will be 10%.

If we assume there is a low chance of default the rate of interest will be low as the company might have a higher credit rating so the rate of interest could be less than 10% as the probabilitry of default is less whereas in case of High Probability of default the expected losses can be higher and thus can increasing the borrowing cost as there is high risk premium that needs to borne by the company for the same.

Formula for expected loss:

Probabilty Of Default* Loss Given Default.