# Does a private company that is 100% financed by a bank loan have a WACC equal to the interest rate?

When estimating a company's Cost of Debt for a Weighted Average Cost of Capital (WACC) calculation we normally look into its bond yield. But for a private company with 100% debt capital structure, will the cost of debt be simply equal to the interest rate? If not why?

• Yes I'd appreciate that Nov 20, 2019 at 21:18

1. the required rate of return of (private) investors is denoted by $$r$$.
2. the interest rate or the cost of debt is denoted by $$r_D$$ (naturally $$r_D < r$$)
3. the share of debt in the capital structure of the company is denoted by $$X\%$$
4. the corporate tax rate is denoted by $$T_c$$

It follows that the average cost of capital (average over equity and debt), $$r'$$, is such that

$$r' = X\% r_D (1-T_c) + (1-X\%) r$$

In your case, $$X\% = 100\% = 1$$, then $$r' = r_D(1-T_c)$$.

[...] will the cost of debt be simply equal to the interest rate? If not why?

No. Because of $$T_c$$, the corporate tax rate being potentially non-zero.

• Any question @Metrician ? Nov 20, 2019 at 22:09
• No that was very clear. Thanks a lot. Nov 20, 2019 at 22:12
• @Metrician and keepAlive, there is another issue besides tax. As Berk & DeMarzo note in Chapter 12 of "Corporate Finance" 4th ed. (see box "Common Mistake" on p. 450), using the debt yield as its cost of capital is a mistake. This is because the interest payments and the repayment of the principal are only promised, not actual. In case of a bankruptcy, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate. Oct 15, 2022 at 13:23
• @keepAlive, I believe there is another issue besides tax. See my answer. Oct 15, 2022 at 13:32

@keepAlive's answer includes a good point about tax but misses another, more subtle issue. As Berk & DeMarzo note in Chapter 12 of "Corporate Finance - 5th Global Edition" (see box "Common Mistake" on p. 454), using the debt yield as its cost of capital is a mistake. This is because the interest payments and the repayment of the principal are only promised, not actual. In case of a bankruptcy, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate on the loan.

This issue is minor to the point that it can be neglected for relatively safe debt (for sure if rated AAA or AA, mostly so if rated A and BBB, according to Table 12.2 on p. 454), but can become pretty significant for high-risk debt (BB and lower, ibid.).

• You are indeed right. The cost of capital I compute is somehow made under a "no bankruptcy" hypothesis. +1 Oct 15, 2022 at 15:34
• @keepAlive, thanks! You may want to check out a related question of mine: "Cost of debt: How to adjust YTM for the possibility of bankruptcy?". Oct 15, 2022 at 15:36