Formula: How to Calculate Cost of Debt

Debt is one part of a company’s capital structure, which also includes equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans. The debt cost is an important financial concept for valuations, merger activity, acquisitions activity, and any event that requires the raising of debt. In debt financing, one business borrows money and pays interest to the lender for doing so. Equity is the amount of cash available to shareholders as a result of asset liquidation and paying off outstanding debts, and it’s crucial to a company’s long-term success.

• 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.
• This value is usually an estimate, particularly if calculated using averages.
• Further, if the company has debts with long payback periods (or longer terms), it will pay more to borrow over time than if it had taken a shorter loan with higher periodic payments.
• 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.
• Then, calculate the interest rate expense for each for the year and add those up.

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. To calculate cost of debt before taxes, divide the total interest of all your loans by the total debt of all your loans. Hence, the cost of debt is NOT the nominal interest rate, but rather the yield on the company’s long-term debt instruments. The nominal interest rate on debt is a historical figure, whereas the yield can be calculated on a current basis. Now, let’s go back to that formula for the cost of debt that includes a tax cost at your corporate tax rate.

What Is the After-Tax Cost of Debt Formula?

The cost of debt finance is the interest payments and the risk of being forced into bankruptcy in the event of nonpayment. Typically the longer debt is financed, the more interest the business pays. Business owners benefit from set payoff amounts and tax write-offs for interest. If you’re unable to find better rates initially, work on improving your business credit score.

The weighted average cost of capital (WACC) is the most common method for calculating cost of capital. Cost of debt is the term that describes how companies repay the lenders and creditors from which they borrow money. Cost of debt is the effective interest rate a company pays to creditors—also known as debt holders or lenders.

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Because of this, investors like to see a healthy mix of financing through both debt and equity. WACC, or weighted average cost of capital, is one way to measure that mix. A business’s cost of debt is determined by the annual interest rate of the funding it borrows, or the total amount of interest a business will pay to borrow. Loan providers use metrics like the state of a company’s business finances and credit rating to come up with the interest rate they will charge a business. The higher a business’s credit score, the less risky they appear to lenders — and it’s easier for lenders to give lower interest rates to less risky borrowers. And the lower your interest rate, the less you pay in interest and on your total cost of debt.

• In an empty cell, type in the formula for cost of debt or before-tax cost of debt.
• The higher a business’s credit score, the less risky they appear to lenders — and it’s easier for lenders to give lower interest rates to less risky borrowers.
• Debt cost is a formula that takes other factors into account when calculating how much a loan costs your business.
• The effective interest rate is defined as the blended average interest rate paid by a company on all its debt obligations, denoted in the form of a percentage.
• The company keeps in mind the rate of interest shown below when borrowing money for the issuance of a bond, as it has to give a fixed rate of interest to an investor who has invested in their company bonds.
• Because money was so cheap to borrow, companies could thrive for years without ever producing a profit.

You’ll be blind to the true cost of your financing, and you might take out another loan you can’t afford. The effective interest rate is defined as the blended average interest rate paid by a company on all its debt obligations, denoted in the form of a percentage. The cost of debt is the interest rate that a company is required to pay in order to raise debt capital, which can be derived by finding the yield-to-maturity (YTM).

How to Calculate After-Tax Cost of Debt?

On the other hand, you might still decide to take out that loan, even if you spend more on interest than you save in tax deductions, if you need the money to grow your business. Debt financing can be a way to raise money relatively quickly, but it won’t come without a substantial ongoing cost in the form of interest expense. A company must also have the credit capacity to add new borrowing to its balance sheet without experiencing a hit to its creditworthiness. Think about how the what is a product might rear its head in everyday life. A family that buys a new home with a large mortgage in 2023 will pay substantially more than if the family bought the same house at the same price in 2020.

The company’s capital cost is the sum of the debt cost plus the equity cost. As you have seen, the cost of debt metric represents how much you pay in interest expenses in relation to the total amount of debt. In other words, it represents the effective interest rate for the company.

Using Debt or Alternatives to Raise Capital

These include a longer payback period, since the longer a loan is outstanding, the greater the effects of the time value of money and opportunity costs. The riskier the borrower is, the greater the cost of debt since there is a higher chance that the debt will default and the lender will not be repaid in full or in part. Backing a loan with collateral lowers the cost of debt, while unsecured debts will have higher costs. The raising capital with debt financing is typically cheaper than equity financing in the long run of a growing company.

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. To know just how much you’re paying in interest, use the following simple formula. As mentioned, there are two ways to calculate the cost of the debt, depending on whether it is pre- or post-tax. It is important to mention that commercial financing is excluded, including commercial creditors, commercial bills payable, and taxes accrued.