Key Takeaways
- Cost of debt reflects the true cost a business pays to borrow money and is essential for making informed financing decisions.
- Both pre-tax and after-tax cost of debt calculations help assess how much interest is actually impacting your bottom line.
- The after-tax cost of debt formula accounts for tax deductions on interest payments, offering a more accurate picture of financing costs.
- Cost of debt is a critical input when calculating your company’s Weighted Average Cost of Capital (WACC) — a core metric in evaluating capital structure.
- Factors such as credit rating, loan terms, market interest rates, and the economic environment directly affect your cost of debt.
- Managing the cost of debt through strategies like refinancing, improving creditworthiness, or negotiating terms can help reduce overall borrowing expenses.
Whether you’re a business owner or entrepreneur, understanding the cost of debt is essential for sound financial decision-making. It could mean the difference between significant growth and overwhelming debt. If you’re looking to learn more, we’re here to help.
This article defines the cost of debt and explains how to calculate it. It also outlines the key factors that influence debt costs.
We’ll also address questions people often have regarding the cost of debt, including:
- What is the cost of debt?
- What is WACC?
- How do you calculate the cost of debt?
What is the Cost of Debt?
Put simply, the cost of debt is the total interest expense a borrower pays when borrowing cash. In other words, it’s the amount you pay a lender for taking on the risk of lending to you.
Having a good handle on the cost of debt puts you in a favourable financial position. Your business’s capital structure is made up of the debt and equity you leverage to fund operational growth and ongoing operations. Cost of debt is a huge piece of the puzzle.
When your cost of debt is low, you’re in a better position to invest in company growth. And when the cost of debt is high, you may see lower profits. Your business will also become less attractive to outside investors and creditors.
Why is the Cost of Debt Important?
The cost of debt is important because of the insight it provides. Companies looking to invest money in a new initiative, project, or growth avenue may have to choose between debt and equity-based funding. With the cost of borrowing clearly defined, borrowers can make more informed decisions about the right debt/equity mix for their needs.
In addition to that, the cost of debt helps you calculate your company’s Weighted Average Cost of Capital (WACC). This calculation involves the cost of debt and the cost of equity capital.
When your WACC is on the lower end, that’s a sign that your business is low-risk for creditors and investors.
How to Calculate the Cost of Debt
Ready to calculate the cost of debt? Below, we’ll walk you through how to determine it both before and after accounting for interest expense deductions.
Pre-Tax Cost of Debt Formula: Use this equation to find out how much interest you pay on debt without accounting for tax benefits. You’ll divide your total interest-bearing expenses by your total debt.
Pre-Tax Cost of Debt = Total Interest Expense
How to Calculate After-Tax Cost of Debt
After-Tax Cost of Debt Formula: This equation takes things further, applying interest-related tax benefits for a more precise result. It requires you to multiply your pre-tax cost of debt by 1 minus the tax rate.
After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1−Tax Rate)
Step-by-Step Calculation Example
Let’s say a company has the following:
- Total debt of $1 million
- Total interest expenses of $200,000
- Tax rate of 25%
Let’s plug the total debt and total interest expense into the Pre-Tax Cost of Debt Formula.
Pre-Tax Cost of Debt = Total Interest Expense/ Total Debt
$200,000 / $1,000,000 = 0.20 or 20%
You’ll use the pre-tax cost of debt (20%) to find the After-Tax Cost of Debt:
After-Tax Cost of Debt = Pre-Tax Cost of Debt x (1−Tax Rate)
0.20 x (1−0.25) = 0.20 x 0.75 = 0.15 or 15%
Factors Impacting the Cost of Debt
A myriad of factors affect the cost of debt, including:
- Credit rating – Your credit rating and report are a measure of how risky it would be to lend to you. Individuals and businesses with lower credit ratings will almost always pay more in debt interest to account for the increased lending risk. Those with good credit have more financial leverage.
- Prevailing interest rates – Canada’s interest rates, set by the Bank of Canada, have a direct effect on the cost of debt. And they change several times a year. When the BoC raises the rate, the cost of debt goes up. And vice versa, when they decrease rates, the cost of debt comes down.
- Loan terms and conditions – Your loan’s specifics (term, schedule of repayment, etc.) also impact financing costs. You’ll often find that shorter-term loans have better interest rates than longer-term options.
- Economic environment – The general economic climate, including inflation and volatility in the market, dictates lender behavior. When the state of the economy is unclear, lower loan interest rates can be hard to come by.
Cost of Debt in WACC
As we briefly mentioned earlier, the cost of debt is essential for accurately calculating the Weighted Average Cost of Capital (WACC). It helps companies determine their overall capital costs.
How to Calculate Cost of Debt for WACC
WACC = (E/V × Re) + (D/V × Rd × (1 – T))
Where:
- E – Equity’s market value
- D – Debt’s market value
- V = E + D (Total value)
- Re – Cost of equity
- Rd – Cost of debt
- T – Corporate tax rate
By integrating the cost of debt into the WACC calculation, businesses can assess whether their financing mix is optimized.
Cost of Debt vs. Cost of Equity
When comparing cost of debt to cost of equity for the purposes of financing, there are a few things to remember:
- Both can help firms secure the funds they need for growth or general operations.
- Equity doesn’t cost money – instead, you’ll relinquish common and preferred stock and ensure healthy operations to generate a good ROI for your investors.
- Debt requires you to repay the funds you borrowed in addition to the interest charged by the lender.
Here’s a side-by-side comparison of both options:
| Criteria | Cost of Debt | Cost of Equity |
| Definition | Interest paid on borrowed capital | Return expected by equity investors |
| Repayment | Must be repaid with interest | No repayment required, but profits may be shared (dividends) |
| Tax Implications | Interest is tax-deductible | Dividends are not tax-deductible |
| Risk Level | Increases financial risk | No repayment obligation, but may dilute ownership |
| Cost Predictability | Usually fixed or known | More volatile, depending on investor expectations |
| Impact on Ownership | No dilution | Dilutes ownership through the issuance of shares |
| Effect on WACC | Helps reduce WACC if rates are favourable | Raises WACC if equity is expensive |
Debt Financing Strategies: Manage and Reduce the Cost of Debt
Debt can be costly for some businesses — especially smaller ones or those with poor credit. Here are a few ways to help keep your debt costs low:
- Take steps to improve your creditworthiness, such as making payments on time.
- Refinance your existing debt to secure lower business loan interest rates.
- Negotiate better terms like lower interest rates or a longer repayment term.
Cost of debt plays a monumental role in a company’s capital structure and corporate debt management. In understanding this concept and the factors affecting it, you can make better informed decisions regarding financing and capital management. Whether you’re seeking a small business loan, line of credit, or other financial relief, grasping the intricacies of cost of debt is vital to achieving lasting business success.
Frequently Asked Questions about Cost of Debt
Why is the cost of debt important for businesses?
It helps companies evaluate financing options, manage capital structure, and determine WACC — an essential metric for assessing the cost of funding.
How does cost of debt affect WACC?
A lower cost of debt reduces WACC, signalling lower overall financing costs and making the company more attractive to investors.
Can small businesses reduce their cost of debt?
Yes. Strategies include improving credit ratings, refinancing at better rates, and negotiating favourable loan terms.
Is cost of debt always better than cost of equity?
Not necessarily. While debt can be cheaper due to tax deductions, it increases repayment obligations and financial risk. The best financing mix depends on your business situation.
How does the economic environment affect the cost of debt?
Fluctuations in interest rates, inflation, and overall market stability can influence lender behaviour. In uncertain times, lenders may increase rates, making debt more expensive.
What’s the difference between pre-tax and after-tax cost of debt?
Pre-tax cost of debt reflects the total interest expense without accounting for tax benefits. After-tax cost of debt includes the tax savings from interest deductions, providing a more accurate view of borrowing costs.
Sources
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