The cost of debt encapsulates the total interest expense owed on a debt. In simpler terms, it is the effective interest rate or the total amount of interest that a company or individual owes on any liabilities like bonds and loans. Depending on the borrower’s creditworthiness, the cost of debt varies, with higher costs indicating higher risk.
Key Takeaways
- The cost of debt is the effective rate a company pays on its debt, including bonds and loans.
- Interest expense is tax-deductible, differentiating the pretax cost of debt from the after-tax cost.
- Debt complements equity in a company’s capital structure.
- 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 represents any money owed by one entity to another. For many, including companies and individuals, taking on debt is inevitable and a common practice to facilitate large purchases or investments, encouraging further growth.
Corporations often include debt in their capital structures alongside equity. The capital structure determines how a firm finances its overall operations and growth through different funding sources, such as bonds or loans.
The cost of debt measure aids in understanding the overall rate paid by a company to leverage these funding sources. Investors can gauge the relative risk level of a company by comparing its cost of debt to others; riskier companies typically face a higher cost of debt. The cost of debt is usually lower than the cost of equity.
Formula and Calculation of Cost of Debt
After-Tax Cost of Debt
To calculate the cost of debt after taxes, use the formula:
ATCD = (RFRR + CS) × (1 - Tax Rate)
Where:
- ATCD = After-tax cost of debt
- RFRR = Risk-free rate of return
- CS = Credit spread
Suppose the risk-free rate of return is 1.5% and the credit spread is 3%. The pretax cost of debt is therefore 4.5%. With a tax rate of 30%, the after-tax cost of debt computed as follows:
(0.015 + 0.03) × (1 - 0.3) = 0.0315 or 3.15%
Before-Tax Cost of Debt
Another approach is determining the total annual interest paid on each debt for the year. Combining the risk-free rate and credit spread results in the pretax cost. For instance, a company with a $1 million loan at 5% interest and a $200,000 loan at 6% results in an average rate of 5.17%:
($1M × 0.05) + ($200K × 0.06) \/ $1.2M = 0.0517
Including a 30% tax rate, the after-tax cost of debt becomes:
0.0517 × (1 - 0.30) = 3.62%
Impact of Taxes on Cost of Debt
Favorable tax codes often allow interest paid on debts to lower the effective cost due to deductions. To determine the after-tax cost:
(interest rate) × (1 - effective tax rate) = after-tax cost
A simpler example involves a bond issued at 5%. With a 30% tax rate, the after-tax cost calculates to 3.5%:
(0.05) × (1 - 0.3) = 0.035 or 3.5%
How to Reduce Cost of Debt
To optimize your financial health, here are several strategies to reduce the cost of debt:
- Negotiating Rates: Consult your lender to negotiate better terms or rates.
- Refinancing: Leverage lower rates by refinancing existing loans, especially long-term commitments like mortgages.
- Increase Payments: Reduce overall interest paid by making higher monthly payments, thus lowering the principal balance faster.
- Improving Credit Scores: Maintaining or increasing your credit score can also secure better interest rates, which translates to a lower cost of debt.
Example of Cost of Debt
Let\u2019s look at a practical example. A business holds loans valued at $250,000 at 5% and $150,000 at 4.5%. The annual interest paid sums up to $19,250:
($250,000 × 0.05) + ($150,000 × 0.045) = $12,500 + $6,750 = $19,250
The pretax interest rate before taxes is then;
$19,250 \/ 400,000 = 0.0481 or 4.81%
Why Does Debt Have a Cost?
Lenders require interest on debt to account for risk, time value of money (TVM), and the potential for loans not being repaid. The yield is what lenders demand, reflecting these financial essentials.
What Makes the Cost of Debt Increase?
Several factors inflate the cost of debt:
- Longer payback periods: Prolonged durations accentuate TVM and other potential financial risks.
- Higher borrower risk: Lower credit rating results in higher interest rates.
- Unsecured debts: loans lacking collateral typically have increased costs.
How Do Cost of Debt and Cost of Equity Differ?
Both debt and equity capital fund business operations but have differing impacts:
- Debt Capital: Usually cheaper due to tax deductions but excessive reliance increases risk.
- Equity Capital: More costly and lacks favorable tax treatment.
What Is the Agency Cost of Debt?
Agency cost of debt highlights conflicts between shareholders and debtholders when debt limits are imposed due to perceived management risks. Debtholders may attach covenants requiring adherence to financial metrics that reassure them against capitalization misuse.
Conclusion
Debt is often a necessary financial tool for substantial purchases or growth financing. Calculating and understanding the cost of debt can help efficiently manage associated expenses and liability impacts.
Related Terms: Capital Structure, Debt Financing, Cost of Equity, Interest Expense, Credit Spread.
References
- Internal Revenue Service. “Topic No. 505, Interest Expense”.
- Internal Revenue Service. “Publication 535 (2022), Business Expenses”.
