What is Cost of Debt Formula?
Cost of debt is the effective interest rate that the company pays on its current liabilities to a creditor and debt holders and is generally referred to the after-tax cost of debt. The difference between the before-tax cost of debt and the after-tax cost of debt is depended on the fact that interest expenses are deductible. Cost of capital of a company is a sum of the cost of debt plus the cost of equity. Cost of Debt formula is given below –
Interest Expenses =Total Debt Obligation x Annual Interest
Examples of Cost of Debt Formula (with Excel Template)
Let’s see some simple to advanced examples to understand the cost of debt equation better.
A company took a loan of $100,000 from a bank at a rate of interest of 6% to issue company bond of $100,000. Based on the loan amount and rate of interest, interest expense will be $6,000 and the tax rate is 20%.
Now using the above data, we have to do the calculation of the cost of debt which will be:-
i.e. Cost of Debt = 6000(1-20%)
Cost of Debt will be –
Therefore, Cost of debt is $4,800.
Now let’s take one more example to understand the formula of interest expense and cost of debt.
Suppose a company has taken a loan from a bank of $1 million for business expansion at a rate of interest of 5%, and the tax rate is 10%. Now we will do the calculation of the cost of debt.
Interest Expenses –
Therefore, the calculation of Cost of Debt will be –
So, Cost of debt will be –
Cost of debt formula = 50,000 (1-10%)
Cost of debt = $45,000
Here, $45,000 is the cost of debt over the life of a loan.
The cost of debt measurement helps to find a financial condition of a company and also help to know risk level of a company as if the debt of the company is high, then risk associated of a company will be high based on which investor take a decision of investment in a company.
So, the cost of debt has a major element tax rate and interest expense. Once the calculation of the cost of debt is done then one can evaluate loan by comparing business income that loan has generated and cost of debt. This cost of debt provides interest expense which later on helps in taxation that will be a tax deduction. This interest expense is used for tax saving purpose by a company as treated as business expenses.
A company has taken a loan of $100,000 from a financial institution for 5 years at a rate of interest of 6%, tax rate applicable is 25%. Now, we will see amortization for the calculation of the cost of debt.
Consider amortization schedule of one year of a loan as given below.
Here, we can see that interest paid by company in one year is:-
Interest Expenses = 500 + 493 + 486 + 478 + 471 + 464 + 456 + 449 + 442 + 434 + 427 + 419 = $ 5,519
In given-below template is the calculation of Cost of Debt Formula –
Therefore, Cost of Debt will be –
Cost of debt formula= 5,519 * (1-25%)
Cost of debt = $4,139
Cost of debt is lower as a principal component of loan keep on decreasing, if loan amount has used wisely and able to generate net income more than $4,139 then taking loan was useful.
What is After-tax Cost of Debt?
The after-tax cost of debt is very important as income tax paid by a company will be low as a company is having a loan on it and interest part paid by a company will be deducted from taxable income. Hence, a cost for debt is crucial as it gives a chance to a company to save its tax. When a company borrows money for the issuance of a bond, it is kept in mind that rate of interest shown below as company has to give a fixed rate of interest to an investor who has invested in their company bonds.
Now, we can see that after-tax cost of debt is one minus tax rate into a cost of debt.
The after-tax cost of debt equation will be as follows:-
Example of After-Tax Cost of Debt Formula (with Excel Template)
Let’s see an example of After-tax Cost of Debt to understand it better.
Suppose a company named AGS Marketing has taken a loan for business expansion of $100,000 at a rate of interest of 7%, tax rate applicable was 25%, here we have to calculate after-tax cost of debt.
i.e. Interest Expense= 100,000 *7=70000
Then in the below template, we have calculated the cost of debt –
i.e. Cost of Debt formula = 70,000 *(1-25%)
Cost of Debt = $52,500
So, the calculation of after-tax cost of debt will be –
i.e. After tax cost of debt formula = 52,500*(1-25%)
After-Tax Cost of Debt will be –
Now, we got after-tax cost of debt that is $39,375
Cost of Debt Calculation in WACC
You can use the following calculator for the calculation of Cost of Debt
|Cost of Debt Formula = Interest Expense * (1 − Tax Rate)|
|0 * (1 − 0) = 0|
Relevance and Use
Uses of Cost of debt equation are as follows:-
- Cost of debt help to save taxes.
- It helps to calculate the risk associated with a company.
- It helps one to calculate net income generated by a company by using loan amount.
- Cost of debt is a component of WACC i.e. Weighted average cost of capital.
- One can also calculate the after-tax cost of debt to know the actual financial position of a company.
There are many ways to lower the cost of debt, they are as follows:-
- Get Cheaper Loan– Cheaper loan means to get a loan at a lower rate of interest which can be done by creating a good credit score by repaying loans on time, offering collaterals, negotiating, etc.
- Refinancing Loan-First one needs to start loan with a rate of interest he is eligible for then when a business starts growing he can refinance your loan with a lower rate after some months of the loan.
- Optimize Business Growth-With an increase in income of a business, one can avail more debt as he will be able to afford it. Cost of debt is compared with income generated by loan amount so, by increasing business income, the cost of debt can reduce.
Cost of debt is a tool which helps one to know that loan availed is profitable for business or not as we can compare the cost of debt with income generated by loan amount in business. The loan can be taken for multiple reasons from the issuance of a bond to buying of machinery prime reason for it is to generate revenue and grow business.
You can download this Cost of Debt Formula Excel Template here – Cost of Debt Formula Excel Template
This has been a guide to Cost of debt Formula. Here we discuss the formula to calculate Cost of Debt in WACC along with practical examples and downloadable excel templates. You can learn more about Financial Analysis from the following articles –