Definition of True interest cost

True interest cost

For a security such as commercial paper that is sold on a discount basis, the coupon rate
required to provide an identical return assuming a coupon-bearing instrument of like maturity that pays
interest in arrears.

Coupon equivalent yield

true interest cost expressed on the basis of a 365-day year.

fractional interest discount

the combined discounts for lack of control and marketability. g the constant growth rate in cash flows or net income used in the ADF, Gordon model, or present value factor.

Accelerated cost recovery system (ACRS)

Schedule of depreciation rates allowed for tax purposes.

Accrued interest

The accumulated coupon interest earned but not yet paid to the seller of a bond by the
buyer (unless the bond is in default).

Agency cost view

The argument that specifies that the various agency costs create a complex environment in
which total agency costs are at a minimum with some, but less than 100%, debt financing.

Agency costs

The incremental costs of having an agent make decisions for a principal.

All-in cost

Total costs, explicit and implicit.

Amortizing interest rate swap

Swap in which the principal or national amount rises (falls) as interest rates
rise (decline).

Average cost of capital

A firm's required payout to the bondholders and to the stockholders expressed as a
percentage of capital contributed to the firm. Average cost of capital is computed by dividing the total
required cost of capital by the total amount of contributed capital.

Bankruptcy cost view

The argument that expected indirect and direct bankruptcy costs offset the other
benefits from leverage so that the optimal amount of leverage is less than 100% debt finaning.

Base interest rate

Related: Benchmark interest rate.

Benchmark interest rate

Also called the base interest rate, it is the minimum interest rate investors will
demand for investing in a non-Treasury security. It is also tied to the yield to maturity offered on a
comparable-maturity Treasury security that was most recently issued ("on-the-run").

Best-interests-of-creditors test

The requirement that a claim holder voting against a plan of reorganization
must receive at least as much as he would have if the debtor were liquidated.

Capitalized interest

interest that is not immediately expensed, but rather is considered as an asset and is then
amortized through the income statement over time.

Carring costs

costs that increase with increases in the level of investment in current assets.

Cash flow after interest and taxes

Net income plus depreciation.

Compound interest

interest paid on previously earned interest as well as on the principal.

Cost company arrangement

Arrangement whereby the shareholders of a project receive output free of
charge but agree to pay all operating and financing charges of the project.

Cost of capital

The required return for a capital budgeting project.

Cost of carry

Related: Net financing cost

Cost of funds

interest rate associated with borrowing money.

Cost of lease financing

A lease's internal rate of return.

Cost of limited partner capital

The discount rate that equates the after-tax inflows with outflows for capital
raised from limited partners.

Cost-benefit ratio

The net present value of an investment divided by the investment's initial cost. Also called
the profitability index.

Covered interest arbitrage

A portfolio manager invests dollars in an instrument denominated in a foreign
currency and hedges his resulting foreign exchange risk by selling the proceeds of the investment forward for
dollars.

Earnings before interest and taxes (EBIT)

A financial measure defined as revenues less cost of goods sold
and selling, general, and administrative expenses. In other words, operating and non-operating profit before
the deduction of interest and income taxes.

Effective annual interest rate

An annual measure of the time value of money that fully reflects the effects of
compounding.

Equilibrium rate of interest

The interest rate that clears the market. Also called the market-clearing interest
rate.

Equivalent annual cost

The equivalent cost per year of owning an asset over its entire life.

Execution costs

The difference between the execution price of a security and the price that would have
existed in the absence of a trade, which can be further divided into market impact costs and market timing
costs.

Financial distress costs

Legal and administrative costs of liquidation or reorganization. Also includes
implied costs associated with impaired ability to do business (indirect costs).

Fixed cost

A cost that is fixed in total for a given period of time and for given production levels.

Forward interest rate

interest rate fixed today on a loan to be made at some future date.

Friction costs

costs, both implied and direct, associated with a transaction. Such costs include time, effort,
money, and associated tax effects of gathering information and making a transaction.

Gross interest

interest earned before taxes are deducted.

Incremental costs and benefits

costs and benefits that would occur if a particular course of action were
taken compared to those that would occur if that course of action were not taken.

Information costs

Transaction costs that include the assessment of the investment merits of a financial asset.
Related: search costs.

Interest

The price paid for borrowing money. It is expressed as a percentage rate over a period of time and
reflects the rate of exchange of present consumption for future consumption. Also, a share or title in property.

Interest coverage ratio

The ratio of the earnings before interest and taxes to the annual interest expense. This
ratio measures a firm's ability to pay interest.

Interest coverage test

A debt limitation that prohibits the issuance of additional long-term debt if the issuer's
interest coverage would, as a result of the issue, fall below some specified minimum.

Interest equalization tax

Tax on foreign investment by residents of the U.S. which was abolished in 1974.

Interest payments

Contractual debt payments based on the coupon rate of interest and the principal amount.

Interest on interest

interest earned on reinvestment of each interest payment on money invested.
See: compound interest.

Interest-only strip (IO)

A security based solely on the interest payments form a pool of mortgages, Treasury
bonds, or other bonds. Once the principal on the mortgages or bonds has been repaid, interest payments stop
and the value of the IO falls to zero.

Interest rate agreement

An agreement whereby one party, for an upfront premium, agrees to compensate the
other at specific time periods if a designated interest rate (the reference rate) is different from a predetermined
level (the strike rate).

Interest rate cap

Also called an interest rate ceiling, an interest rate agreement in which payments are made
when the reference rate exceeds the strike rate.

Interest rate ceiling

Related: interest rate cap.

Interest rate floor

An interest rate agreement in which payments are made when the reference rate falls
below the strike rate.

Interest rate on debt

The firm's cost of debt capital.

Interest rate parity theorem

interest rate differential between two countries is equal to the difference
between the forward foreign exchange rate and the spot rate.

Interest rate risk

The risk that a security's value changes due to a change in interest rates. For example, a
bond's price drops as interest rates rise. For a depository institution, also called funding risk, the risk that
spread income will suffer because of a change in interest rates.

Interest rate swap

A binding agreement between counterparties to exchange periodic interest payments on
some predetermined dollar principal, which is called the notional principal amount. For example, one party
will pay fixed and receive variable.

Interest subsidy

A firm's deduction of the interest payments on its debt from its earnings before it calculates
its tax bill under current tax law.

Interest tax shield

The reduction in income taxes that results from the tax-deductibility of interest payments.

Market impact costs

Also called price impact costs, the result of a bid/ask spread and a dealer's price concession.

Market timing costs

costs that arise from price movement of the stock during the time of the transaction
which is attributed to other activity in the stock.

Net financing cost

Also called the cost of carry or, simply, carry, the difference between the cost of financing
the purchase of an asset and the asset's cash yield. Positive carry means that the yield earned is greater than
the financing cost; negative carry means that the financing cost exceeds the yield earned.

Nominal interest rate

The interest rate unadjusted for inflation.

Open interest

The total number of derivative contracts traded that not yet been liquidated either by an
offsetting derivative transaction or by delivery. Related: liquidation

Opportunity cost of capital

Expected return that is foregone by investing in a project rather than in
comparable financial securities.

Opportunity costs

The difference in the performance of an actual investment and a desired investment
adjusted for fixed costs and execution costs. The performance differential is a consequence of not being able
to implement all desired trades. Most valuable alternative that is given up.

Pooling of interests

An accounting method for reporting acquisitions accomplished through the use of equity.
The combined assets of the merged entity are consolidated using book value, as opposed to the purchase
method, which uses market value. The merging entities' financial results are combined as though the two
entities have always been a single entity.

Price impact costs

Related: market impact costs

Rate of interest

The rate, as a proportion of the principal, at which interest is computed.

Real interest rate

The rate of interest excluding the effect of inflation; that is, the rate that is earned in terms
of constant-purchasing-power dollars. interest rate expressed in terms of real goods, i.e. nominal interest rate
adjusted for inflation.

Replacement cost

cost to replace a firm's assets.

Round-trip transactions costs

costs of completing a transaction, including commissions, market impact
costs, and taxes.

Search costs

costs associated with locating a counterparty to a trade, including explicit costs (such as
advertising) and implicit costs (such as the value of time). Related:information costs.

Short interest

This is the total number of shares of a security that investors have borrowed, then sold in the
hope that the security will fall in value. An investor then buys back the shares and pockets the difference as profit.

Shortage cost

costs that fall with increases in the level of investment in current assets.

Simple interest

interest calculated only on the initial investment. Related:compound interest.

Spot interest rate

interest rate fixed today on a loan that is made today. Related: forward interest rates.

Stated annual interest rate

The interest rate expressed as a per annum percentage, by which interest
payment is determined.

Sunk costs

costs that have been incurred and cannot be reversed.

Times-interest-earned ratio

Earnings before interest and tax, divided by interest payments.

Trading costs

costs of buying and selling marketable securities and borrowing. Trading costs include
commissions, slippage, and the bid/ask spread. See: transaction costs.

Transactions costs

The time, effort, and money necessary, including such things as commission fees and the
cost of physically moving the asset from seller to buyer. Related: Round-trip transaction costs, Information
costs, search costs.

True lease

A contract that qualifies as a valid lease agreement under the Internal Revenue code.

Variable cost

A cost that is directly proportional to the volume of output produced. When production is zero,
the variable cost is equal to zero.

Weighted average cost of capital

Expected return on a portfolio of all the firm's securities. Used as a hurdle
rate for capital investment.

Cost basis

An asset’s purchase price, plus costs associated with the purchase, like installation fees, taxes, etc.

Cost of goods sold

The cost of merchandise that a company sold this year. For manufacturing companies, the cost of raw
materials, components, labor and other things that went into producing an item.

MACRS (Modified Accelerated Cost Recovery System)

A depreciation method created by the IRS under the Tax Reform Act of 1986. Companies must use it to depreciate all plant and equipment assets installed after December 31, 1986 (for tax purposes).

Absorption costing

A method of costing in which all fixed and variable production costs are charged to products or services using an allocation base.

Activity-based costing

A method of costing that uses cost pools to accumulate the cost of significant business activities and then assigns the costs from the cost pools to products or services based on cost drivers.

Avoidable costs

costs that are identifiable with and able to be influenced by decisions made at the business
unit (e.g. division) level.

Cash cost

The amount of cash expended.

Cost

A resource sacrificed or forgone to achieve a specific objective (Horngren et al.), defined
typically in monetary terms.

Cost behaviour

The idea that fixed costs and variable costs react differently to changes in the volume of
products/services produced.

Cost centre

A division or unit of an organization that is responsible for controlling costs.

Cost control

The process of either reducing costs while maintaining the same level of productivity or maintaining costs while increasing productivity.

Cost driver

The most significant cause of the cost of an activity, a measure of the demand for an activity
by each product/service enabling the cost of activities to be assigned from cost pools to products/services.

Cost object

Anything for which a measurement of cost is required – inputs, processes, outputs or responsibility centres.

Cost of capital

The costs incurred by an organization to fund all its investments, comprising the risk-adjusted
cost of equity and debt weighted by the mix of equity and debt.

Cost of goods sold

See cost of sales.

Cost of manufacture

The cost of goods manufactured for subsequent sale.

Cost of quality

The difference between the actual costs of production, selling and service and the costs that would be incurred if there were no failures during production or usage of products or services.

Cost of sales

The manufacture or purchase price of goods sold in a period or the cost of providing a service.

Cost-plus pricing

A method of pricing in which a mark-up is added to the total product/service cost.

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