Cost of Debt Formula: What It Means and How To Calculate It

cost of debt formula

This means that the after-tax cost of debt is lower than the before-tax cost of debt. The YTM refers to the internal rate of return (IRR) of a bond, which is a more accurate approximation of the current, updated interest rate if the company tried to raise debt as of today. The question here is, “Would it correct to use the 6.0% annual interest rate as the company’s cost of debt? For example, a bank might lend $1 million in debt capital to a company at an annual interest rate of 6.0% with a ten-year term. Let’s say you want to take out a loan that will allow you to write off $2,000 in interest for the year.

cost of debt formula

Because your tax rate is 40%, that means you end up paying $40 less in taxes. Suppose a company named AIM Marketing has taken a loan for business expansion of $500,000 at the rate of interest of 8%. The tax rate applicable was 30%; here, we have to calculate the after-tax cost of debt. In this guide, you will learn about the cost of debt, as well as how to calculate it before and after taxes have been paid. You will also learn how to use Microsoft Excel or Google Sheets to calculate the cost of debt and how a tool like Layer can help you synchronize your data and automate calculations.

How to Calculate Cost of Debt?

Get a Cheaper Loan
A cheaper loan means to get a loan at a lower rate of interest which can be done by creating a good credit score by repaying loans on time, offering collaterals, negotiating, etc. Now, we can see that the after-tax cost of debt is one minus tax rate into the cost of debt. Now let’s take one more to understand the formula of interest expense and cost of debt. Using the “IRR” function in Excel, we can calculate the yield-to-maturity (YTM) as 5.6%, which is equivalent to the pre-tax cost of debt. To arrive at the after-tax cost of debt, we multiply the pre-tax cost of debt by (1 — tax rate). With that said, the cost of debt must reflect the “current” cost of borrowing, which is a function of the company’s credit profile right now (e.g. credit ratios, scores from credit agencies).

cost of debt formula

The cost of debt before taking taxes into account is called the before-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible. This formula is useful because it takes into account fluctuations in the economy, as well as company-specific debt usage and credit rating. If the company has more debt or a low credit rating, then its credit spread will be higher. There are a couple of different ways to calculate a company’s cost of debt, depending on the information available.

Examples of the Cost of Debt Formula

Interest is the cost of borrowing and is tax deductible by the firm; in bankruptcy, bondholders are paid before shareholders as the firm’s assets are liquidated. Default risk is the likelihood the firm will fail to repay interest and principal when required. Interest paid by the firm on its current debt can be used as an estimate of the current cost of debt if nothing has changed since the firm last borrowed. The analyst would then use the interest rates paid by these comparably rated firms as the pretax cost of debt for the firm being analyzed. Much of this information can be found in local libraries in such publications as Moody’s Company Data; Standard & Poor’s Descriptions, the Outlook, and Bond Guide; and Value Line’s Investment Survey. In the United States, the FINRA TRACE database also is an excellent source of interest rate information.

Follow the steps below to calculate the cost of debt using Microsoft Excel or Google Sheets. Therefore, the final step is to tax-affect the YTM, which comes out to an estimated 4.2% cost of debt once again, as shown by our completed model output. For the next section of our modeling exercise, we’ll calculate the cost of debt but in a more visually illustrative format. Remember, the discounted cash flow (DCF) method of valuing companies is on a “forward-looking” basis and the estimated value is a function of discounting future free cash flows (FCFs) to the present day. As we learned from our pre-tax calculation, our effective interest rate is 8%. Then, divide total interest by total debt to get your cost of debt.

Gather Data

Specific forms of alternative financing (and the components of the capital structure of the firm) are preferred stock, retained earnings, and new common stock. To figure the pre-tax cost of debt for your business, start by adding your total interest expenses for the year. There are numerous ways to secure business capital, and debt financing is at the top of that list. With debt financing, your business borrows money from a lender—often in the form of a short term loan or business line of credit—and agrees to repay those funds plus interest in the future.

  • Don’t waste hours of work finding and applying for loans you have no chance of getting — get matched based on your business & credit profile today.
  • Knowing the after-tax cost of the debt you’re taking on is crucial when trying to stay profitable.
  • For example, mention if you’ve calculated the weighted average cost of capital as part of a school project or for your personal investing activities.
  • If its effective tax rate is 30%, then the difference between 100% and 30% is 70%, and 70% of the 5% is 3.5%.

A company’s total cost of debt is calculated by adding total interest expense and dividing it by total debt. The cost of debt is a critical measure because it directly impacts a company’s profitability and cash flow. A high debt cost also indicates a higher level of financial risk for a company. So, the weighted average cost of capital looks at a company’s capital structure and compares equity and debt to their respective proportions of the capital structure.

Related terms:

Taking on too much debt, especially in a rising rate environment, can lead to excessive interest payments, putting pressure on operations and putting the company at more risk of default. Those, aside from Netflix, are some seriously low costs of debt, which show how strong all of these companies’ financials cost of debt formula are, and the low cost of debt they can access to pursue additional growth projects. To better understand the impact of tax savings on the cost of debt and earnings, let’s look at a simple example. To calculate the after-tax cost of debt, we need first to determine the pretax cost of debt.

In other words, it represents the effective interest rate for the company. The cost of debt can be calculated before and after taxes, as interest expenses are tax-deductible. Additionally, the cost of debt is used to calculate other important financial metrics, such as the weighted average cost of capital (WACC). Debt and equity capital both provide businesses with the money they need to maintain their day-to-day operations. Equity capital tends to be more expensive for companies and does not have a favorable tax treatment.

Cost of Debt Examples

Each year, the lender will receive $30 in total interest expense twice. The diligence conducted by the lender used the most recent financial performance and credit metrics of the borrower as of that specific period (i.e. the past), as opposed to the current date. This article currently has 45 ratings with an average of 3.5 stars. We can add these two figures together to get the total annual interest, which is $19250. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.

cost of debt formula

It is a tool that helps one know whether that loan is profitable for business as we can compare the cost of debt with income generated by loan amount in business. Multiple reasons exist for taking out a loan, ranging from issuing bonds to purchasing prime machinery in order to generate revenue and grow the business. It helps to know the actual cost of debt, and debt helps to justify the cost of debt in the business. The after-tax cost of debt is high as income tax paid by the company will be low as the company has a loan on it, and the interesting part paid by the company will be deducted from taxable income. Hence, the cost of debt is crucial as it gives a chance to a company to save its tax.

Currently, the US effective tax rate for corporations is 21%, but Congress might raise those rates per the sitting president’s wishes. If those rates do rise, that will impact the cost of debt for every publicly traded company and is something to keep in mind. But those higher interest rates translate to higher interest payments for that company, which leads to a higher cost of debt on the balance sheet. It also leads to lower accounting earnings on the income statement. Simply put, the cost of debt is the after-tax rate a company would pay today for its long-term debt. Estimating the cost of debt is relatively straightforward, but there are a few items you need to keep in mind when using the cost of debt formula.

Each capital investment carries a financial cost, and the two main sources of company investment are equity and debt. We accept payments via credit card, wire transfer, Western Union, and (when available) bank loan. Some candidates may qualify for scholarships or financial aid, which will be credited against the Program Fee once eligibility is determined. Please refer to the Payment & Financial Aid page for further information. While reviewing balance sheets and other financial statements can help answer this question, a firm grasp of financial concepts—such as cost of capital—is critical to doing so. Acquirer Inc., a US-based corporation, wants to purchase Target Inc.

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