What Should Be Counted in Debt?
Analystsareoftenfacedwithadifficultquestionofwhatto
include in debt, given that debt can be short-term or
long-term,securedorunsecured,andfloatingorfixedrate.In
addition,wehavetodecideonwhatotherliabilitieswewant
toincludeinthedebtcomponent.Whilethetemptationoften
isto be conservativeand include allpotentialliabilities as
debt,this canprove counterproductive sinceincreasing the
debtwilloftenreducethecostofcapital(andincreasefirm
value). In general, we would recommend including the
following items in debt:
All Interest-Bearing Liabilities
Most publicly traded firms have multiple
borrowings—short-termandlong-termbondsandbankdebt
withdifferenttermsandinterestrates.Whiletherearesome
analystswhocreateseparatecategoriesforeachtypeofdebt
andattachadifferentcosttoeachcategory,thisapproachis
bothtediousanddangerous.Usingit,wecanconclude that
short-term debt is cheaper than long-term debt and that
secured debtis cheaper thanunsecured debt, eventhough
neither of these conclusions is justified. The solution is
simple.Combineall debt—short-and long-term,bank debt
and bonds—andattachthelong-term cost ofdebt toit. In
otherwords,addthedefaultspreadtothelong-termrisk-free
rateandusethatrateasthepretaxcostofdebt.Firmswill
undoubtedly complain, arguing that their effective cost of
debt can be lowered by using short-term debt. This is
technicallytrue,largely becauseshort-termratestendtobe
lowerthanlong-termrateswithupward-slopingyieldcurves,
but itmisses the pointof computing thecost of debtand