The cost of debt
/What is the Cost of Debt?
The cost of debt is the after-tax effective rate paid by a borrower on its debt. The cost of debt will vary based on several factors, which are as follows:
Credit rating of the borrower. A borrower with a sterling credit rating can borrow funds at a lower rate, and so will experience a lower cost of debt.
Payment speed of the borrower. A borrower that pays its debts early will incur a lower total interest expense, while one that pays late will incur not only the full amount of interest expense, but also penalties and fines.
The applicable tax rate. If the applicable income tax rate is high, then the interest expense paid will shield a larger proportion of net income, resulting in a lower cost of debt. The reverse situation occurs when the applicable tax rate is low.
The cost of debt comprises a portion of the total cost of capital of a business, of which the other parts are the cost of preferred stock and the cost of equity. The cost of debt is the least expensive part of the cost of capital, since it is tax deductible. Given the lower cost of debt, there is a temptation to take on an excessive amount of debt in comparison to the other elements of the cost of capital; however, doing so increases the amount of loan principal to be repaid, as well as interest, which increases the bankruptcy risk of the firm.
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Why the Cost of Debt is Important
Debt is the least-expensive portion of the cost of capital. This means that businesses tend to load up on debt when they need additional funding, rather than selling shares of their preferred stock or common stock. An increase in interest rates also increases the cost of debt, which makes it more expensive to fund projects within a business. This means that more marginal proposed projects are dropped, since it is no longer cost-effective to invest in them. Conversely, when the cost of debt declines, it is now cost-effective to invest in projects that have a reduced expected return on investment.
How to Calculate the Cost of Debt
Follow these steps to calculate the cost of debt:
Calculate the aggregate amount of interest to be paid over a one-year period.
Calculate the average amount of debt outstanding during the one-year period.
Divide the aggregate amount of interest by the average debt level to arrive at the pre-tax interest rate.
Subtract the organization’s tax rate from 1, and multiply the difference by the pre-tax cost of debt.