How To Calculate The Cost Of Debt?
Posted on: June 14, 2022 | Category: Business Credit·Cash Flow·Fund Your Business·Taxes
The volume of capital you take on has a big impact on the form of your business finances. The cost of debt gives you the knowledge you need to decide if you can afford to take on the debt. A debt calculator can also help you estimate the exact cost a company pays for the loan.
When calculating the possible revenue you might expect from the loan, the duration becomes increasingly important. If your loan has a healthy potential, you know it’s worth taking the risk; if it doesn’t, you might as well consider other ways to achieve your business objectives.
What is the Cost of Debt?
Cost of debt refers to the effective interest expense that a business pays on its debts, for instance, loans and bonds. It can either refer to the after-tax cost of debt (the cost of debt after taxes) or to the pre-tax cost of debt (before tax cost debt).
The idea that interest expenses undergo tax deductions is the main difference between the pre-tax cost and after-tax cost of debt. In comparison to the cost of equity, calculating the cost of debt is relatively simple because a total debt obligation, such as loans and bonds, has clearly visible market interest rates.
How the Cost of Debt Works?
A company’s capital structure consists of debt and equity capital. Several sources of funds and capital finance a business’s operations and expansion, which may include borrowing via bonds or loans under a capital structure.
Measuring the cost of debt is useful for understanding the overall interest rate that a company pays to employ this sort of debt. It also proves helpful in determining the company’s risk level compared to others. A high cost of debt can also give investors information about how risky a company is in comparison to others. It will help you with the balance sheet too. A higher cost of debt indicates that the company is more vulnerable.
Businesses can raise cash for free cash flows via two methods, namely through equity capital and debt. An angel investor or a venture capitalist invests money in exchange for a stake of ownership in the former.
A business obtains funds and cash flow for its operations through the debt equity mechanism. This can take the form of a loan, a merchant cash advance, or invoice financing, among other options. Businesses return the loans with interest over several months or years, depending on the loan agreement terms.
Cost of debt is a sophisticated corporate finance indicator that outside investors, investment bankers, and lenders use to assess a company’s capital structure and determine whether it is too risky to participate in.
Calculating a business’s weighted average cost of capital (WACC), which assesses how well a business must perform to appease all of its stakeholders, includes calculating the cost of debt.
How to Calculate Cost of Debt?
To calculate the cost of debt for your business, you don’t need to be a hedge fund manager or a bank. You can do tax savings easily.
Simply add up the total of all of your company’s credit card balances, loans, and other financing options. Then, for each year, compute and add the average interest rate expense. To calculate your total debt cost, divide your total interest by your entire debt. However, if your loans have deductible interest expenses, you can easily look forward to some income tax savings.
Calculating the after-tax debt cost is useful in this case. You’ll need to know your company’s effective tax rate to do so. At this point, knowing about the WACC of your debt is also crucial. This is the total interest you’re paying on all of your debts. Multiply each loan by the interest expense rate to find out the weighted average interest rate of expense.
Businesses evaluate their cost of debt to see how big of a strain their loans are imposing on their operations and whether it’s prudent to take on more. Knowing your total debt cost might help you figure out how much you’re paying for the convenience of future cash flows.
Examples of Cost of Debt:
Depending on the information accessible, there are a few different approaches to assessing a company’s cost of debt. Generally, there are two methods to calculate the cost of debt, depending on whether you are considering it as a pre-tax or post-tax cost.
Simple Cost of Debt: This merely calculates the interest you are paying. The cost of debt is equivalent to the total interest expense divided by the total debt.
For example, if your total debt is $50,000 and the total interest you are paying on all your loans for the current year is $3,500, then the simple cost of debt will be 7%.
Complex Cost of Debt: This helps you to get familiar with how the cost of debt changes after taxes.
Effective interest rate multiplied by (1 – tax rate)
Suppose the weighted average interest rate for all loans is 6.5%. This figure actually comes in the effective interest rate field. Next, suppose the corporate tax rate is 9%. Then,
Cost of debt = 6.5% * (1 – 9%) = 5.9%
What is the After-Tax Cost of Debt?
Interest is tax-deductible and has a monetary value. Most people value the after-tax cost of debt over the pre-tax cost of debt in this regard.
You’ve added your taxes to your debt in the case of after-tax, and that’s what you’re paying. The initial cost of debt is modified for the impacts of the incremental income tax rate to calculate the after-tax cost of debt.
The after-tax cost of debt financing varies according to a company’s marginal tax rate. If a company’s profits are small, it will be taxed at a lower interest rate, which implies that the after-tax rate will climb. Conversely, as the company’s profits grow, it will be liable for a higher tax rate, lowering its after-tax debt cost.
Businesses factor the after-tax cost of debt into the company’s cost of capital calculation. The other part of the cost of capital is the cost of equity.
How to Calculate After-Tax Cost of Debt?
After-tax cost of debt = Pre-tax cost or the Effective tax rate * (1- tax rate)
The figure obtained after using this debt formula is, basically, the cost of debt that is factored into the weighted average cost of capital calculation.
Example of After-tax Cost of Debt:
Suppose your company’s tax rate of 40% and the effective rate is 5.5%, then the after-tax cost of debt is calculated as follows:
After-tax Cost of Debt = 5.5% x (1 – 0.4) = 3.3%.
Why does the Cost of Debt Matter to a Small Business?
To function properly and handle day-to-day operations, every small business requires finance. To make investments, undertake marketing and research, and pay off debt, capital in the form of debt or equity can be utilized.
Debt capital, on the other hand, permits a corporation to leverage a modest sum of money into a much larger number; nevertheless, lenders often demand fixed interest payments in return.
Furthermore, loan money does not dilute the company owner’s ownership interest. Annual interest payments until the debts are paid off, on the other hand, can take a long time, particularly when interest rates are rising.
Especially in the beginning, almost all small firms are on the hunt for finances and debts. As a result, understanding the idea of the cost of debt becomes vitally important for the business’s long-term viability.
Calculating these data allows them to see into the future and see how hopeful the future seems, as well as what steps they need to take to have a good run in the domain.
FAQS:
Why is the Cost of Debt Lower Than Equity?
Debt is safe and less risky than equity. The minimum return required to repay debt investors is lower than the minimum return required to repay equity investors. Consequently, the cost of debt is lower than the cost of equity.
Due to the obvious difference in the corporate tax treatment of interest and dividends, debt is also less expensive than equity from a company’s perspective.
Interest is removed from the profit and loss statement before the tax is calculated, giving corporation tax benefits on interest.
For businesses that are profitable and anticipated to perform well, the debt is generally less expensive than equity. This is because the cost of debt is finite, and the company will have no further debt obligations to the lender after the complete repayment of the business loan.
To put it another way, the more prosperous a firm is or will be, the more expensive it is to give up the equity because it is better for an owner to just keep the profits and pay the interest.
What Is the Difference Between the Cost of Debt and the Cost of Equity?
Debt and equity financing are the two primary forms of capital for businesses. Both supply the required cash to keep a business solvent, but they have significant distinctions. While both methods of financing have advantages, they also have disadvantages.
Debt capital entails the repayment of the borrowed funds at a later date. This refers to any type of growth capital that a firm obtains through the use of debt. There are long-term and short-term loans available, such as overdraft protection.
Debt financing does not dilute the owner’s interest in the company. Interest paid until the loans are paid off, on the other hand, can take a long time, especially when interest rates are rising.
The cost of equity capital is slightly more complicated because it often originates from funds invested by shareholders. A business does not have to take on debt to access equity financing. Henceforth, they do not have to return or repay the amount.
However, based on market behavior in aggregate and the unpredictability in question, the debt holders might reasonably expect some level of return on investment. To keep the debt holder committed, companies must be able to deliver returns that meet or exceed this level, such as robust stock prices and dividends.
To calculate the expected rate of return or cost of equity, the capital asset pricing model uses the risk-free rate, the risk premium of the wider market, and the beta value of the company’s shares.
What Makes the Cost of Debt Increase?
Here are some of the reasons why the cost of a loan rises based on the lender’s risk:
Longer payback duration: If a company’s debt is outstanding for a lengthy time, it signals a larger risk. It also has an impact on the time value of money.
Unsecured debts: Loan collateral reduces borrowing costs. Unsecured debts, alternatively, will be more expensive.
Borrower risk is too high: A borrower with a higher risk has a higher debt cost. This is due to the possibility that the repayments will not be completed in full.
How to Lower Your Cost of Debt?
Any loan is a good idea if the cost of debt is minimal. However, if it’s more, you might want to consider other low-interest options.
Begin by carefully selecting your finances. Low-interest business loans are the finest, but if your business or personal credit rating isn’t strong enough, you may not be eligible for those lower rates.
Maintain a good payment history by paying your bills on time to have a good balance sheet.
Reduce your company’s debt utilization. Both of these tactics will eventually improve your credit rating. Contemplate consolidating at a lower rate if you have excessive total interest paid on one or more debts.
Why should I measure the Cost of Debt?
Calculating and keeping track of your debt costs will reveal whether or not you’re overspending on debt. When calculating the tax cost, it can also tell you if taking on specific types of debt is a wise choice.
