From NIC to TIC to RAY: Estimating Lifetime Cost of Capital for Municipal Borrowers

Cost of capital metrics for state/municipal government and not-for-profit borrowers have evolved over time from net interest cost (NIC) to true interest cost (TIC) and its variants. These metrics are not optimal because they either ignore the likelihood of refinancing altogether or make refinancing assumptions that may not be applicable to the municipal bond market, which presents a future debt service schedule that does not adequately reflect such refinancing activity. Ignoring the possibility of a future refinancing altogether or modeling future refinancings differently can result in wide variation in capital cost estimates because the majority of fixed-rate, municipal bond issues are callable and issued with premium coupon rates that make future refinancings highly likely. This paper describes an alternative lifetime cost of capital metric called refunding adjusted yield (RAY), which incorporates refinancing probabilities using the issuer’s own refinancing criteria in calculating cost of capital. RAY offers significant advantages in optimal bond structuring and is a more comprehensive and complete metric for use in financial policy decisions involving true capital cost.