Loooking for debt financing? Don’t know which debt to take? This article will explore cost of debt and how you can calculate it to make financing decisions.
It is exciting and interesting living a spontaneous life, but when it comes to financing, chances aren’t so great.
While a spur-of-the-moment trip to Paris or a casual skydiving excursion might sound exciting, taking out a spontaneous loan definitely doesn’t sound like a good idea.
Debt financing is an important component in the system of corporate capital structure, but business owners would be not be recommended to use it without deciding what it’s going to cost them in the long run. This is when the cost of debt comes in. After interest and tax, how much does issuing bonds or taking out a term loan actually cost a company? Learn more about the cost of debt, how to calculate cost of debt, after tax cost of debt , cost of debt yield to maturity and more.
What is cost of debt?
The cost of debt indicates how much debt a company owes its lenders. It is most commonly shown as a decimal stating the rate of interest the company owes, but can also be expressed as an amount of money it owes in interest.
Calculating the cost of debt is also an element of deciding a company’s weighted average cost of capital, or WACC, which not only accounts for the cost of debt, but the cost of equity as well, and is used to evaluate the stability of a company’s capital structure.
How to calculate cost of debt?
Lenders, investors, and business owners calculate the cost of debt in several ways, but the most used cost of debt formula is:
Cost of Debt = Interest Expense (1 – Tax Rate)
Appears like a simple enough formula, but it can get perplexing because different lenders quote interest expense in various ways, and businesses have different tax rates based on their location and how they’re structured.
- The first step is to calculate your business’s average income tax rate, which you’ll insert for “tax rate” in the formula. You can either ask your accountant for this or use a tax schedule to forecast your business tax rate. Note that you must account for federal, state, and local taxes. To do so, divide your total tax liability by your total taxable business income. This will provide you your business’s average income tax rate.
- The second step is to get hold of the total interest cost of the loan, which you’ll insert for “interest expense” in the formula. The total interest cost should consist of any loan fees that are tax-deductible (because you’ll be adjusting for taxes in the formula). Calculating total interest cost can be difficult because some lenders quote an annual percentage rate (APR), but others quote a factor rate or the total payback amount. Ask the lender to find the total interest cost for you, or use a business loan calculator. APR is the most correct interest rate because it also includes fees.
Once you have the total interest cost and your average tax rate, you’re after all ready to use the cost of debt formula. Let’s start with a simple example to see how the formula works.
Cost of Debt Examples
The example below will help you figure out how to calculate cost of debt.
Let’s assume an acquaintance gives you a $100,000 loan at an interest rate of 15%, and your business has a 25% average tax rate. To make it simple let’s presume that the interest is applied upfront to the principal (i.e. no compounding or amortization).
The cost of debt would be calculated as follows:
Cost of Debt = 15,000 (1 – .25) = 15,000 – 3,750 = $11,250
In this example, the cost of debt over the life of the loan is $11,250. With this value in hand, you can now evaluate the cost of debt to the net income that the loan will create. If the debt results in increased growth that’s more useful than the cost, then the loan is a good business investment.
For example, say the loan in our example will pay for a promotional campaign that you estimate
will produce $50,000 in business income. In this case, the loan is definitely worth the cost. But if that campaign will only generate $10,000 in income, it is recommended not to take the loan—at least at the current interest rate and terms. In that case, you should resume exploring around for a more reasonably priced business loan.
What is the after-tax cost of debt?
The after-tax cost of debt is the net cost of debt calculated by adjusting the gross cost of debt for its tax benefits. It equals the pre-tax cost of debt multiplied by (1 – tax rate). It is the cost of debt that is incorporated in the calculation of the weighted average cost of capital (WACC).
Tax laws in many countries permit deduction on account of interest expense. This deduction leads to a reduction in taxable income and a resulting reduction in income tax. The reduction in income tax due to interest expense is called the interest tax shield. Because of this tax benefit of interest, the effective cost of debt is lower than the gross cost of debt.
After-tax cost of debt formula
The after-tax cost of debt can be calculated using the following formula:
After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 – Tax Rate)
The gross or pre-tax cost of debt amount to yield to maturity of the debt. The applicable tax rate is the marginal tax rate. When the debt is not marketable, the pre-tax cost of debt can be calculated by comparing it with the yield on other debts with the same credit quality.
ABC company has earnings before interest and taxes of $200 million. It has an interest-bearing debt of $50 million carrying an 8% interest rate. The company’s marginal tax rate is 35%. Find the after-tax cost of debt in the dollar and in percentage.
Cost of debt (i.e. interest expense) is $4 million [= $50 million × 8%].
Earnings before taxes
= $200 million – $4 million
= $196 million
= $196 million × 35%
= $68.6 million
= $196 million × (1 – 35%)
= $196 million – $68.6 million
= $127.4 million
If there were no debt, there would be no interest expense, and tax expense would be $70 million [=$200 million × 35%]
The presence of debt has decreased tax expense by $1.4 million [= $70 million – $68.6 million] and this is the interest tax shield.
The actual cost of debt i.e. the after-tax cost of debt is as follows
The after-tax cost of debt
= total cost of debt – interest tax shield
= $4 million – $1.4 million
= $2.6 million
In percentage terms, the after-tax cost of debt = 8% × (1 – 35%) = 5.2%. This exactly equals the ratio of after-tax interest expense in dollars to the principal balance of debt (i.e. $2.6 million/$50 million = 5.2%).
Why the after-tax cost of debt is important for small businesses?
According to the U.S. Federal Reserve, 43% of small businesses will look for external funding for their business at some point—most often some kind of debt. Being aware of the after-tax cost of the debt you’re taking on is important when striving to stay profitable.
For instance, let’s assume you know that a piece of new equipment would boost your revenues by 5%. You don’t have enough cash on hand to afford it completely, so you look around for a loan. The most reasonable one you can find has an after-tax cost of 7%. Should you take it?
Unless you think there’s some way the equipment could help you increase revenues by more than 7%, you shouldn’t take out the loan, because the extra revenues you’ll earn will be outstripped by the extra interest payments you’re making.
Similar to any other cost, if the cost of debt is more than the extra revenues it brings in, it’s a bad investment.
Cost of Debt Yield to Maturity
Yield to maturity (YTM) is the total return expected on a bond if the bond is held until it matures. Yield to maturity is deemed as a long-term bond yield but is stated as an annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as planned and reinvested at the same rate.
Yield to maturity is also termed as “book yield” or “redemption yield.”
Yield to maturity is somewhat like current yield, which divides annual cash inflows from a bond by the market price of that bond to decide how much money one would make by purchasing a bond and holding it for one year. But, unlike current yield, YTM accounts for the present value of a bond’s future coupon payments. In other words, it factors in the time value of money, but a simple current yield calculation does not. As such, it is every so often deemed as more comprehensive means of calculating the return from a bond.
The YTM of a discount bond that does not pay a coupon is a good beginning place in order to comprehend some of the more complicated issues with coupon bonds. The formula to calculate YTM of a discount bond is as follows:
YTM = -1
n=number of years to maturity
Face value=bond’s maturity value or par value
Current price=the bond’s price today
Cost of Debt Yield-to-Maturity Example
Let’s take an example to make it easier for you to understand this.
Suppose that a company has issued a bond to raise funds.
The YTM will be the rate at which the present value of all cash flows = $1,050.
We can use a financial calculator to solve for i. In this case, i = 3.643%, which is the six-month yield. The annualized yield will be 7.286%.
Given a tax rate of 35%, the after-tax cost of debt will be = 7.286% (1-35%) = 4.736%.
How to lower your cost of debt?
So why make effort to determine your cost of debt? Because it informs you whether or not you’re spending too much on financing. It can lets you know whether taking on some type of debt is a good idea when you determine the tax cost.
Let’s assume you want to take out a loan that will permit you to write off $2,000 in interest for the year. If the cost of debt is less than $2,000, the loan is a good idea. But if it’s more, you might want to explore other options with lower interest costs. However, you might still choose to take out that loan, even if you spend more on interest than you save in tax deductions if you need the money to expand your business.
So how can you lower your cost of debt? Begin by selecting your financing wisely. The best business loans are those that offer low rates, but if your personal or business credit scores aren’t high, you may not be eligible for those lower interest costs.
Work on developing your credit scores by paying your bills on time and enhancing your debt utilization. If you have high-interest payments on one or more loans, think about consolidating at a lower rate.
How to calculate cost of debt on a financial calculator?
To determine your business’ total cost of debt—also occasionally called your business’ effective interest rate—you are supposed to do three things:
- First, calculate the total interest expense for the year. If your business generates financial statements, you can typically find this figure on your income statement. (If you assemble these quarterly, add up total interest payments for all four quarters.)
- Sum up all of your debts. You can generally find these under the liabilities section of your company’s balance sheet.
- Divide the first figure (total interest) by the second (total debt) to get your cost of debt.
This isn’t a precise calculation, because the amount of debt you bear over the course of the year can change. (If you want to be more accurate, calculate the average amount of debt you carried for the year throughout all four quarters.)
Cost of Debt Bond Calculator
There are numerous bond pricing calculators which informs you what a bond should trade at depending upon the par value of the bond and current yields available in the market. The cost of debt bond calculator sums the present value of the bond’s future cash flows to deliver price.
Cost of Debt Calculator Online
The interest you incur on your debt can instantly become very costly. Use cost of debt calculator online to help decide just how expensive your debt has become. Insert all of your credit cards and outstanding instalment loan balances. Find out how much you owe, how much interest you are slated to pay and how long it will take to pay it all off.
Cost of debt formula is a tool which facilitates one to find out that loan taken is profitable for business or not as we can compare the cost of debt with income produced by loan amount in business. The loan can be taken for various reasons from the issuance of a bond to buying of machinery, the most important reason for it is to produce revenue and boost business. It also assists in knowing the cost of capital of a business. Cost of debt formula facilitates to know the actual cost of debt and also helps to explain the cost of debt in the business.