Which Cost of Debt Should be Used in Forecasting Cash Flows? (Updated)

Abstract

Frequently analysts and teachers use the capitalized rate of interest for the cost of debt when forecasting and discounting cash flows. On the other hand, some authors (and analysts) estimate the interest payments when forecasting annual financial statements or cash flows based on the average of debt calculated with the beginning balance and the end of year balance. This makes some sense because usually firms repay debt in a monthly or quarterly basis and calculating interest payments might not reflect reality. Others use the end of year convention that calculates the yearly interest multiplying the beginning balance times the contractual cost of debt.

In this teaching note we show the differences when we use those different approaches and make a simple proposal to solve the problem.

Keywords: Cost of debt, forecasting financial statements, seasonality

JEL Classification: G30, G31, G32