How to measure the true cost of debt? - Views on News from Equitymaster

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How to measure the true cost of debt?

Mar 15, 2011

Apart from equity, debt is an important source of finance for any company. It not only provides an alternative cheaper source of funding (when compared to equity) but also entails lower issuance cost. Issue expenses for raising money via debt are generally lower when compared to raising equity through primary or secondary markets. Due to this dual advantage of cheaper access to funds and lower issuance cost, companies typically resort to debt financing. And the companies which are generally more prone to use debt in their capital structure are from real estate and construction sector. Hence, an accurate measurement of cost of debt for these companies is extremely important.

In this article, we try to present an accurate way of measuring the true cost of debt for real estate and construction companies. Let's say you are confronted with the financial statements of any real estate or construction company and asked to calculate the cost of debt for any of them. How would you go about it? Intuitively, you would divide the interest cost present in the income statement by the total debt lying on the company's balance sheet. This is something which any person with a reasonable financial background would do.

Now if you were to repeat this process for say last 10 years for any real estate or construction company you would find that the average cost of debt would be anywhere between 8-11%. Doesn't that surprise you?

A business that is typically leveraged (has gone on to add more debt) has virtually managed to keep its cost of debt more or less in a tight band. This appears to be strange, isn't it?

Traditional finance theories state that cost of the debt for every rupee of incremental debt taken should be higher as the company is exposed to higher credit risk with increasing levels of debt. But that is not evident from the financial statements of these companies. So are these companies able to obtain a bargain purchase option due to the sheer size of their loans - Or is there something more to it? We try to explain it over here.

Typically, real estate and infrastructure companies do not expense their entire interest expense in the income statement. Interest paid on project specific debt is capitalized to the cost of the asset. Hence, construction interest basically bypasses the income statement.

Lets us assume that a construction/real estate company has taken a debt to the extent of Rs 1 bn to build a particular structure/building. And the interest rate applicable to this debt is 10% pa. Apart from this it also has taken a debt of another Rs 500 m to meet its working capital requirements which has an interest rate of 10% pa. According to the accounting standards, the company will report an interest expense of Rs 50 m (on the working capital debt) onto the income statement. However, the interest expense of Rs 100 m on the debt taken to fund the project cost has to be capitalized (as the benefits are going to accrue over time).

If the project/asset is characterized an inventory (as it would be for a real estate firm) the interest cost (of Rs 100 m) would subsequently flow on to the income statement as COGS. However, if the project/asset is a characterized as a fixed asset (as it would be for an EPC firm) the interest cost (of Rs 100 m) will subsequently flow onto the income statement as depreciation.

Hence, the overall interest cost and thus the true cost of debt is basically camouflaged in this whole process. The right way to gauge the actual cost of debt is to plug in the capitalized interest into the process of calculating the overall cost of debt. This would give us a true measure of the actual cost of debt for any real estate or construction firm.

Now we guess it would have been clear to you as to how these companies have managed to report a stable cost of debt over these years despite leveraging themselves to the maximum extent possible. Although capitalizing interest cost on project specific debt is the right way to record the said transaction, (as benefits of the projects will accrue over time) for analytical purposes it is necessary to adjust the capitalized interest so as to get a true measure of the actual cost of debt.

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