Cost of Debt: How to Calculate Cost of Debt

To calculate the weighted average interest rate, divide your interest number by the total you owe. If you’re just focusing on your loan’s monthly payment and not diving in deeper to analyze the true cost you’re paying, you might be spending more than necessary on your debt financing. Even though you’re paying your friend $100 in interest, because of the $40 in savings, really you’re only paying an additional $60. The after-tax cost of debt is lower than the pre-tax cost of debt. As a result, debtholders will place covenants on the use of capital, such as adherence to certain financial metrics, which, if broken, allows the debtholders to call back their capital.

Observable interest rates often contribute to quantifying cost of debt. Therefore, the cost of debt of a company reflects both its risk of default as well as the interest rates in the market. https://www.bookstime.com/accounting-services-for-startups Additionally, it is also a component in calculating Weighted Average Cost of Capital (WACC). The cost of debt is the return provided to the debtholders and creditors of a company.

What Does WACC Tell You?

Although you can use Excel or Google Sheets for bookkeeping, it’s helpful to know how to be your own cost of debt calculator. To find your total interest, multiply each loan by its interest rate, then add those numbers together. Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling. It gives a good idea of the adjusted rate the companies pay and helps them decide whether to use debt or equity funding.

• To express the cost of capital in a single figure, one has to weigh its cost of debt and cost of equity proportionally, based on how much financing is acquired through each source.
• As companies add new debt to their balance sheets, their average cost of debt increases; in dollar terms, they’ll see a higher interest expense on their income statement.
• It is a single rate that combines the cost to raise equity and the cost to solicit debt financing.
• As we learned from our pre-tax calculation, our effective interest rate is 8%.
• WACC is also important when analyzing the potential benefits of taking on projects or acquiring another business.
• Ltd has taken a loan from a bank of $10 million for business expansion at a rate of interest of 8%, and the tax rate is 20%.

Essentially, the interest rate demanded by creditors is the cost of the debt. When the creditors give a loan, they estimate the risks and the borrower’s chances of repayment of the debt. Various factors like the inflation, risk, and time value of the money need to be taken into account, which helps the business and creditors determine if the process is worthy enough.

What Net Debt Indicates

Next, assuming the loans above all have fixed interest rates, you would calculate the total annual interest expense as follows. Next, it’s important to understand that there are multiple ways to calculate cost of debt. Two of the most common approaches to the cost of debt formula are to calculate the after-tax cost of debt and the pre-tax cost of debt. Below is a closer look at the cost of debt formula for each option.

• It is expressed as either the before-tax (the amount owed by the business before taxes) or the after-tax.
• Additionally, collaboration and synchronization can be problematic if you work as part of a team.
• In simplified terms, cost of debt (or debt cost) is the interest expense you pay on any and all loans your business has taken out.
• It, therefore, becomes extremely critical to have learned about the concepts of cost of debt for the sustainability of the business.
• Therefore, the weighted cost of equity would be 0.08 (0.8 × 0.10).
• The agency cost of debt refers to the dispute that arises between shareholders and debtholders of a public company.

WACC is used as the discount rate when performing a valuation using the unlevered free cash flow (UFCF) approach. Discounting UFCF by WACC derives a company’s implied enterprise value. Equity cost of debt formula value can then be be estimated by taking enterprise value and subtracting net debt. To obtain equity value per share, divide equity value by the fully diluted shares outstanding.

Before-Tax Cost of Debt

The amount paid in interest expenses varies from item to item and is subject to fluctuations over time. Since observable interest rates play a big role in quantifying the cost of debt, it is relatively more straightforward to calculate the cost of debt than the cost of equity. Not only does the cost of debt reflect the default risk of a company, but it also reflects the level of interest rates in the market. In addition, it is an integral part of calculating a company’s Weighted Average Cost of Capital or WACC. The after-tax cost of debt generally refers to the difference between the before-tax cost of debt and the after-tax cost of debt, which is dependent on the fact that interest expenses are deductible.

Even though a firm does not pay a fixed rate of return on common equity, it does often pay cash dividends. Then, multiply that by your effective interest rate, or weighted average interest rate, to get your after-tax cost of debt. The cost of debt you just calculated is also your weighted average interest rate. This rate will help us complete our next calculation — after-tax cost of debt.

Why does the cost of debt matter?

It’s also the hurdle rate that companies use when analyzing new projects or acquisition targets. If the company’s allocation can be expected to produce a return higher than its own cost of capital, then it’s typically a good use of funds. Many companies generate capital from a combination of debt and equity (such as stock) financing. To express the cost of capital in a single figure, one has to weigh its cost of debt and cost of equity proportionally, based on how much financing is acquired through each source.

When obtaining external financing, the issuance of debt is usually considered to be a cheaper source of financing than the issuance of equity. One reason is that debt, such as a corporate bond, has fixed interest payments. The larger the ownership stake of a shareholder in the business, the greater he or she participates in the potential upside of those earnings. Now, back to that formula for your cost of debt that includes any tax cost at your corporate tax rate. The total interest you’d pay your friend for that loan would be $100, all of which you can deduct on your taxes, which means your total taxable income goes down by $100. Because your tax rate is 40%, that means you end up paying $40 less in taxes.

To see if your tax savings will cover your interest expenses, you’ll use a different formula to calculate your cost of debt after taxes. Unlike debt financing, equity financing is a financial instrument without a fixed rate of return. Investors buy stock in a firm with the hope that they will get dividends in the future as their investment will grow over time. As with most calculations, the first step is to gather the required data. To calculate the total cost of debt, you need the value of the total debt, as well as the total interest expense related to the total debt.

Determining the debt cost helps companies determine the rate of money paid by the company to finance its debt regularly. Fortunately, the information you need to calculate the cost of debt can be found in the company’s financial statements. The cost of debt metric is also used to calculate the Weighted Average Cost of Capital (WACC), which is often used as the discount rate in discounted cash flow analysis.

In the case of after-tax, you’ve added your taxes to your debt and that’s what you’re paying. Beta refers to the volatility or riskiness of a stock relative to all other stocks in the market. The first and simplest way is to calculate the company’s historical beta (using regression analysis). Alternatively, there are several financial data services that publish betas for companies.