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Which cost of debt should be used in forecasting cash flows?

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  • Ignacio Velez-Pareja

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 andmake a simple proposal to solve the problem.

Suggested Citation

  • Ignacio Velez-Pareja, 2007. "Which cost of debt should be used in forecasting cash flows?," Proyecciones Financieras y Valoración 4318, Master Consultores.
    • Handle: RePEc:col:000463:004318
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    References listed on IDEAS

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    1. Ignacio Vélez-Pareja & Rauf Ibragimov & Joseph Tham, 2008. "Constant Leverage And Constant Cost Of Capital: A Common Knowledge Half-Truth," Estudios Gerenciales, Universidad Icesi, June.
    2. Ignacio Vélez-Pareja, & Julián Benavides-Franco, 2006. "There exists circularity between WACC and value? Another solution," Estudios Gerenciales, Universidad Icesi, March.
    3. Benninga, Simon, 2006. "Principles of Finance with Excel," OUP Catalogue, Oxford University Press, number 9780195301502.
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    More about this item

    Keywords

    Cost of debt; forecasting financial statements; seasonality;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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