The Cost of Debt

Abstract:     
We estimate firm-specific marginal cost of debt functions for a large panel of companies between 1980 and 2007. The marginal cost curves are identified by exogenous variation in the marginal tax benefits of debt. The location of a given company's cost of debt function varies with characteristics such as asset collateral, size, book-to-market, intangibility, cash flows, and whether the firm pays dividends. By integrating the area between the benefit and cost functions we estimate that the equilibrium net benefit of debt is 3.5% of asset value, resulting from an estimated gross benefit of debt of 10.4% of asset value and an estimated cost of debt of 6.9%. We find that the cost of being overlevered is asymmetrically higher than the cost of being underlevered and that the cost of default makes up approximately half of the total ex ante cost of debt.

Keywords: capital structure, cost of debt

JEL Classifications: G30, G32

Working Paper Series