The Cost of Debt

In the paper, The Cost of Debt, which is forthcoming in the Journal of Finance, we use panel data from 1980 to 2007 to estimate the marginal cost function for corporate debt. This is the first explicit estimate of the cost of debt function in the literature. We use variation in debt tax benefit curves to help us map out the marginal cost function. We employ two identification strategies: (i) a full panel approach using all time-series and cross-sectional information from 1980 to 2007, (ii) a time series approach focused on the 1986 Tax Reform Act.

The estimated marginal cost of debt functions are positively sloped. The location of the function depends on firm characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. Our findings are robust to firm fixed effects, year fixed effects, across time periods, and when accounting for fixed adjustment costs of debt. We provide an easy-to-use formula that allows others to create firm-specific marginal cost of debt functions. We also provide firm-specific recommendations of optimal debt policy against which firms’ actual debt choices can be benchmarked, and we quantify the welfare costs to the firm from deviating from the model-recommended optimum.

Our estimates indicate that the optimal capitalized net benefits of debt are about 3.5% of asset value, though they are much higher for some firms. We also find that the cost of overlevering is greater than the cost of underlevering, which may explain why some firms use debt conservatively. Finally, our estimates are benchmarked to several papers, including Almeida and Phillippon (2007). We find that default cost of debt amounts to approximately half of total cost of debt, implying that agency costs and other non-default costs contribute about half of the total ex ante costs of debt.

The full paper is available for download here.