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. 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.
- The cost of debt is the interest rate a borrower must pay on borrowed money, such as bonds or loans.
- Investors may look at a company’s debt costs and avoid getting involved if those costs are too high or too low.
- This tax break lowers the amount of interest debtholders pay, which lowers their cost of debt.
- On the Bloomberg terminal, the quoted yield refers to a variation of yield-to-maturity (YTM) called the “bond equivalent yield” (or BEY).
- While the cost of debt is the rate of return that lenders expect from borrowers, the cost of equity is the rate of return that shareholders expect from companies they hold partial ownership in.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein. Transform the way your team collaborates with Confluence, a remote-friendly workspace designed to bring knowledge and collaboration together.
Cost of Debt Examples
The total cost of debt is influenced by the interest rate on each loan the business takes out. The rate is determined by the lender and is based on a variety of factors. To get our total interest, we’ll multiply each loan by its annual interest rate, then add up the results. Calculating your cost of debt will give you insight into how much you’re spending on debt financing.
We would look at the leverage ratios of the company, in particular, its interest coverage ratio. Debt and equity are two ways that businesses make money, but they are very different. While we now know that the cost of debt is how much a business pays to a lender to borrow money, the cost of equity works differently.
What Makes the Cost of Debt Increase?
In this article, we’ll discuss how to find the cost of debt and how to use that knowledge to guide your company to success. In other words, cost of debt is the total cost of the interest you pay on all your loans. If you’re a small business owner, you know that borrowing money is both inevitable and essential. You need working capital to get your business off the ground or grow it to new heights. The cost of debt is the return that a company provides to its debtholders and creditors. These capital providers need to be compensated for any risk exposure that comes with lending to a company.
Knowing the after-tax cost of the debt you’re taking on is crucial when trying to stay profitable. In an empty cell, type in the formula for cost of debt or before-tax cost of debt. Because interest rates have been rapidly rising throughout 2022 and may continue to rise in early 2023, it may be difficult to find low-interest rate options. If that’s the case, you may want to consider ways to get out of debt or reduce the debt at your company. However, when interest rates began rising in 2022, borrowed money no longer looked so appealing. Companies had to scramble to cut costs, deleverage, and shrink down to a size that is sustainable in today’s high-interest rate environment.
Impact of Taxes on Cost of Debt
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. If you also want to calculate the after-tax cost of debt, you will need the tax rate. The effective interest rate is the weighted average interest rate we just calculated.
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. 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). The cost of debt is the interest rate a borrower must pay on borrowed money, such as bonds or loans.
What Determines the Cost of Debt?
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 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. 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.
Debt Financing: A Game-Changer for Your Business or a Recipe for Disaster?
And the lower your interest rate, the less you pay in interest and on your total cost of debt. The rationale behind this calculation is based on the tax savings that the company receives from claiming its interest as a business expense. To continue with the above example, imagine the company has issued $100,000 in bonds at a 5% rate.