The cost of debt is an integral part of debt financing.

Companies have to take loans at some point of time.

The reason why a lender agrees is because of the return they can earn.

The cost of debt is directly linked to the rate of return.

In many ways, it is also a measure of the risk involved.

Inevitably high-risk companies also have a higher cost of debt.

In fact, the cost of debt formula can help you identify the rate of interest for the loan.

The formula helps you understand the monthly cost it involves.

That clearly helps you make a reasonable assessment of the kind of expense involved.

You can then easily take a call on the overall cost-return ratio.

In fact, debt is one of the most used financing means.

It is cheaper, less time consuming and involves lesser obligation.

Debt financing is also hassle-free and easily organizable.

Businesses can often get this kind of loans in a matter of days.

Therefore, the cost of debt also becomes an important element.

It helps you calculate the exact cost involved in the entire process.

## The Basics of Cost of Debt

On an average, the cost of debt refers to the money involved after tax.

Companies also have a cost of debt number before tax.

The difference in the two figures is the overall tax deduction.

Most interest costs are tax deductible. Different businesses get different types of rebate based on their turnover, operation.

Therefore, the cost of debt also takes into account the cost of equity.

In fact, this cost forms an integral part of the company’s capital structure.

Companies have to document the exact interest every year.

This includes the total interest paid against every debt separately.

When the total amount is divided by the total number of debt, you get the cost.

This is the overall cost of debt for a business on an annual basis.

Let’s say my company X issued \$1 million worth bonds at 5% interest.

So, the interest component in the first one equals \$50,000.

I also took a loan worth \$2 million at 7% interest rate.

The interest on it equals \$140,000.

There was another loan worth \$200,000 at 6% rate.

So I have to pay \$12,000 interest.

Therefore, my total debt for the year is more than \$3 million.

The total interest outgo on this is over \$200,000.

The cost of debt, therefore, is a little over 6%.

But here, I have to keep some key factors in mind.

This includes the cost before tax and the cost after tax.

The tax component, therefore, is a crucial element in calculating the cost of debt.

Let’s assume you have a bond issue at 5% interest rate.

If the tax rate is about 40%, the effective rate of interest is 3%.

So that is the actual cost of debt.

## The Tax Factor in Cost of Debt

You will agree that the tax element is very important.

The cost of debt formula will never be perfect without it.

Most importantly you have to carefully compute the after-tax numbers.

This is what will give you the exact interest amount in dollar terms.

Based on these numbers, the company can calculate the exact interest burden.

This is important while allocating funds for future.

Let’s say I can only pay \$5 million a year as debt expenses.

I am already paying about \$3 million as the cost of debt.

I have the option to spare just \$2 million for all other expenses.

So proper computation of the cost of debt will help you evaluate prospects better.

Even when you are looking for companies to invest, this is a relevant parameter.

Identifying the cost of debt is also crucial to determine absolute valuation.

## The After-Tax Cost of Debt Formula

So we already know that actual cost of debt is interest minus tax deduction.

This after-tax cost of debt is significant in assigning the risk profile.

The higher the rate of interest, more is the risk with this company.

Once you have a clear idea of this amount, it is time for the corporate tax.

This is the tax that every business has to pay to the Government.

On an average, US businesses pay 15-35% of income as taxes.

Different types of businesses have different rates of taxes as well.

You have to take this amount into consideration for appropriate calculation.

The next key element in this is the individual interest rate on your debt.

The adjusted rate of interest is calculated on the basis of these numbers.

This adjusted rate takes the corporate tax and interest rate into consideration.

You have to multiply the overall interest rate by 1 and subtract the tax amount.

This will be the final adjusted interest rate.

Let me explain using a simple example.

My company pays 35% tax, and I issue a bond at 5% interest rate.

So the adjusted rates will be 3.25%.

That is 1-35% and multiplying the difference by 5%.

Therefore, this is the adjusted rate of interest for the debt.

In other words, my creditors will get this return for the money they have loaned me.

You must remember in this case even the bond buyers are lenders for me.

Taking this adjusted rate, you can now calculate the annual cost of debt.

You have to multiply the entire adjusted rate by the debt amount.

A sum of all will be the net debt cost.

## Take a Note of Company’s Exact Outstanding Debt

But the after-tax rate is only one aspect of the overall puzzle.

There are many factors to identify the exact debt amount.

First and foremost, you will have to consider the entire outstanding amount.

A lot of companies have all details in their financial statement.

In that case, it is fairly simple.

You have to take all the details and add them together.

Often companies also list out their annual debt size as well.

This will give you details of the debt liability overall.

That simplifies the mathematics, and all you need to make is a simple addition.

## Cash Flow Statement

The cash flow statement is another important factor in calculating the cost of debt.

Often the interest cost is calculated on the basis of cash flow statements.

So, any adjustment on the cash flow will affect the final interest rate.

As a result, the cost of debt formula will also take this into account.

Your cash flow statement is often a reflection of the actual expenses.

So any changes in this will impact the overall rate.

It will also be closely linked to the pre-tax rate.

Now, remember the adjusted interest rate considers both the pre and post-tax rate.

So, your overall computation needs to very specific.

Whatever cost of debt formula you might use, this is a key factor.

This will keep your actual cost of debt relevant.

It can often be the most defining element while making final calculation.

Often this is the basic loophole of debt financing.

If you fail to take any of these numbers into account, it will impact your final rate.

That means your calculation will not be precise.

Often the cost of debt decides the future capex plans.

Needless to mention that even this gets impacted in that case.

## The Effective Tax Rate

In this context, there is another key factor to remember.

Perhaps that will explain why the pre-tax and after-tax rates are so important.

Well, they go on to help finalize the effective tax rate.

This by far gives the most accurate cost of debt details.

The financial statement can tell you what happened so far.

But to calculate future allocation, business owners have to make their own calculation.

The effective tax rate can help you back calculate most relevant details.

So, in this case, you are just going reverse of the after-tax cost of debt formula.

You will first subtract the tax rate from one.

Now divide the difference by the after-tax rate.

This will give you a fair idea of the pre-tax expenses.

As a result, you can then calculate the cost of debt in a more precise manner.

## Calculating the Average Cost of Debt

When you consider the cost of debt formula, there is another factor.

This is the average cost of debt.

You have to understand that debt financing has many variants.

So, different types of debt instruments are used for this purpose.

Now the cost of debt will be different for each of these.

Now we already offered a cost of debt formula for doing so individually.

But let’s face it, this will be difficult for smaller companies.

But for bigger firms, it will not be practical.

They take different types of loans.

There can be a loan against instruments, property loans and loan against vehicles.

Normally the idea is to get maximum fund and bear the minimum cost.

How will you manage this is the question.

So, a simple solution is looking for the average cost of debt.

In this, the individual cost of debts are combined and averaged out.

So then you get the company’s average cost of debt.

Needless to mention, you have to consider the after-tax rates.

That will be more precise and closer to the actual expenses.

This necessitates the weighted cost of debt individually.

You can then use that figure to compute the weighted average cost.

## How to Compute the Weighted Average Cost of Debt?

Now the next concern is getting a grip on the weighted average cost.

This is particularly important in case of large corporates.

They use many different types of debt instruments.

Even from a stock buyer’s perspective, this will help assign better value.

First of all, you must compute all the separate after-tax rate.

Now you will have to average the specific costs based on the varying rates of interest.

You also need to calculate how much share a specific debt has of the total debt.

Let me use an example for better and clear explanation.

Company X is planning major expansion.

So, the company actively looks for lucrative debt financing options.

Let’s say the total debt for the company is now \$100,000.

Now they took two loans.

One of the loans was worth \$75000, and the after-tax cost of debt was 6%.

In case of the other loan worth \$25000, the tax cost of debt was 3%.

Now you already know the average cost of debt formula.

You add up the two separate costs of debt.

So that is a little over 5% but less than 6%.

You can well understand, this is the mean amount.

Though not exact, it will be able to guide you on the overall rate a lot better.

## Cost of Debt Formula for Auto & Property Loans

The cost of debt formula incorporates different elements together.

So, here first let us train our guns on the standard formula for home and auto loans.

Normally the Payment equals the result of dividing loan amount by discount.

Of course, you have to consider the number of payments each year.

Different loans have different terms.

So your cost of debt formula will have to account for that.

The number of years over which the payment is planned is also an essential element.

Normally the periodic rate of interest is the annual rate divided by payment instances.

So let us go back to my previous example.

The total loan amount was \$100,000 and the after-tax rate at 6%.

Let’s assume you will repay the loan in 30 years.

So, how much will be paid on a monthly basis?

So total number of payments is 30x 12 monthly payment every year.

That makes the total number of payment a product of the two at 360.

At 6% interest rate, the cost of debt is 0.005.

Again I am dividing 0.06 by 12 payments every year on a monthly basis.

So the discount factor is calculated as per the formula.

Discount= ({[(1+.005)^360] – 1} / [.005(1+.005)^360])= 166.7916

Therefore, my monthly payment is 100,000 divided by 166.7916 at 599.55

## Interest Only Loan

Now, this is a formula for vehicle and property loans.

What if Company X decided to go for interest-only loans.

The loan payment formula for this is also crucial.

This is because it will have a bearing on the final cost of debt for the company.

This is a fairly straightforward calculation.

The annual interest rate multiplies the loan amount in this case.

The product is then divided by the number of payments every year.

So continuing with our example of \$100,000 loan at 6%, we get \$6000 interest.

This is the annual interest rate.

Now 6000 is divided by 12 payments a year.

You get the monthly loan amount of \$500.

That is the monthly outgo which you have to factor in.

But in this case, you are not repaying any of the principal amount.

You are only paying the interest portion.

To get rid of the debt entirely, you will have to make this entire payment.

## Credit Card Loans

When you are calculating the cost of debt, this is another factor.

Most small businesses use a lot of credit card loans.

Especially in case of startups, when entrepreneurs have limited resources.

How do you calculate the monthly payment outgo?

On an average, you will have to pay about 3% of the outstanding amount.

So the monthly payment is a product of minimum % payment and actual balance.

## The Cost of Debt Is an Integral Part of the Company’s Balance Sheet

It is a sum of the various loan liabilities that a company has.

The cost of debt does not just highlight the amount loaned.

It brings to focus the actual cost the company has to bear due to the loan.

In the real world, businesses cannot wish away debt financing.

But can the debt balloon to disproportionate level?

Yes, it can and totally destabilize the business too.

So the cost of debt acts as a stabilizing agent.

It highlights the actual cost involved.

Businesses can then plan their future fund allocation effectively.

Moreover, they can prioritize and pay off more expensive loans faster.

The cost of debt formula carefully takes into account the different elements.

That makes the formula more precise.

So if you want effective debt financing, you have to pay attention to the cost of debt.