Defining the cost of debt

What is the cost of debt?

The cost of debt is the effective interest rate that a business pays on its debts, such as bonds and loans. The cost of debt can refer to the cost of debt before taxes, which is the company’s cost of debt before taxes, or the cost of debt after taxes. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax deductible.

Key takeaways

  • The cost of debt is the effective rate that a business pays for its debt, such as bonds and loans.
  • The key difference between the cost of debt and the after-tax cost of debt is the fact that interest expense is tax deductible.
  • Debt is one part of the capital structure of a company, and the other is capital.
  • Calculating the cost of debt involves finding the average interest paid on all of a company’s debts.

How the cost of debt works

Debt is a part of the capital structure of a company, which also includes capital. The capital structure deals with how a company finances its general operations and growth through different sources of funds, which can include debt such as bonds or loans.

The cost of debt measure is helpful in understanding the overall rate a business pays to use these types of debt financing. The measure can also give investors an idea of ​​the risk level of the company compared to others because riskier companies generally have a higher cost of debt.

Examples of cost of debt

There are a couple of different ways to calculate the cost of debt for a business, based on the information available.

The formula (risk-free rate of return + credit spread) multiplied by (1 – tax rate) is a way to calculate the after-tax cost of debt. The risk-free rate of return is the theoretical rate of return on an investment with zero risk, most commonly associated with US Treasuries. A credit spread is the difference in yield between a US Treasury bond. And another debt security of the same maturity but of different credit quality.

This formula is useful because it takes into account fluctuations in the economy, as well as the use of company-specific debt and credit rating. If the business has more debt or a low credit rating, its credit spread will be higher.

For example, let’s say the risk-free rate of return is 1.5% and the company’s credit spread is 3%. The cost of debt before taxes is 4.5%. If your tax rate is 30%, the after-tax cost of debt is 3.15%. [(.015+.03)*(1-.3)].

As an alternative way to calculate the cost of debt after taxes, a business could determine the total amount of interest it is paying on each of its debts during the year. The interest rate that a business pays on its debts includes both the risk-free rate of return and the credit spread from the formula above, because the lender will take both into account when initially determining an interest rate.

Once the business has its total interest paid for the year, it divides this number by the total of all its debt. This is the company’s average interest rate on all of its debt. The after-tax cost of debt formula is the average interest rate multiplied by (1 – tax rate).

For example, suppose a business has a loan of $ 1 million with an interest rate of 5% and a loan of $ 200,000 with a rate of 6%. The average interest rate and cost of debt before taxes is 5.17%. [($1 million * .05) + ($200,000 * .06) / $1,200,000]. The company’s tax rate is 30%. Therefore, your after-tax cost of debt is 3.62%. [.0517 * (1 – .30)].

Impact of taxes on the cost of debt

Since interest paid on debts often receives favorable treatment in tax codes, tax deductions due to outstanding debts can reduce the effective cost of debt paid by a borrower. The after-tax cost of debt is the interest paid on the debt less any income tax savings due to deductible interest expense. To calculate the after-tax cost of debt, subtract a business’s effective tax rate from 1 and multiply the difference by its cost of debt. The company’s marginal tax rate is not used, but the company’s state and federal tax rates are added together to determine its effective tax rate.

For example, if the only debt of a company is a bond that it has issued at a rate of 5%, the cost of the debt before taxes is 5%. If your effective tax rate is 30%, the difference between 100% and 30% is 70% and 70% of 5% is 3.5%. The after-tax cost of debt is 3.5%.

The basis for this calculation is based on the tax savings the business receives from claiming its interest as a business expense. To continue with the previous example, imagine that the company has issued $ 100,000 in bonds at a rate of 5%. Your annual interest payments are $ 5,000. Claim this amount as an expense, and this reduces the company’s revenue by $ 5,000. Because the business pays a tax rate of 30%, it saves $ 1,500 in taxes by canceling its interest. As a result, the company only pays $ 3,500 on its debt. This equates to a 3.5% interest rate on your debt.

Frequent questions

Why does debt have a cost?

Lenders require borrowers to pay back the principal amount of a debt, as well as interest, in addition to that amount. The interest rate, or yield, that creditors demand is the cost of debt: it is required to take into account the time value of money, inflation and the risk that the loan will not be repaid. It also involves the opportunity costs associated with the money used for the loan that is not used elsewhere.

What makes the cost of debt go up?

Various factors can increase the cost of debt, depending on the level of risk to the lender. These include a longer payback period, as the longer a loan is outstanding, the greater the time value effects and opportunity costs. The riskier the borrower, the higher the cost of debt, as there is a greater chance that the debt will default and the lender will not be fully or partially repaid. Backing up a loan with collateral reduces the cost of debt, while unsecured debt will have higher costs.

How are the cost of debt and the cost of equity different?

Both debt and equity provide businesses with the money they need to run their day-to-day operations. Equity capital tends to be more expensive for companies and does not have such a favorable tax treatment. However, too much debt financing can lead to solvency problems and increase the risk of default or bankruptcy. As a result, companies seek to optimize their weighted average cost of equity (WACC) on debt and equity.

What is the cost of agency debt?

Debt agency cost is the conflict that arises between shareholders and debtors of a public company when debtors impose limits on the use of the company’s capital if they believe that management will take actions that favor equity shareholders instead. of debtors. As a result, debt holders will enter into covenants on the use of capital, such as meeting certain financial metrics, which, if broken, allow debt holders to recover their principal.

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Mark Holland

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