Introduction
As a CFO, you may prefer a mix of equity and internal financing instead of just debt on the balance sheet. Sometimes, you use debt financing to pursue business strategies without sacrificing ownership shares. However, accumulating too much debt limits your organization’s financial flexibility during economic volatility. That’s why it’s essential to be aware of the cost of debt and its impact on cash flow.
The cost of debt is the total interest expense an organization owes to borrowers for liabilities. This article walks you through the basics of the cost of debt, how it works, its tax implications, and more.
Read More: What are Assets and Liabilities? Understand the Difference
What is the cost of debt?
The cost of debt is the total interest amount or effective interest rate a company owes on debt instruments like bonds and loans. In other words, the cost of debt is the minimum interest rate debt holders need to offer financing support to borrowers. The total debt cost can be before or after tax.
Debt holders determine the annual interest rate based on the borrower’s credit score. A lower credit rating results in higher costs and vice versa. Lenders also scrutinize business financial statements to assess borrowers’ creditworthiness and loan repayment capabilities.
Since interest expenses are tax deductible, businesses usually calculate the cost of debt after deducting taxes. As a result, the pre-tax cost of debt is always lower than the after-tax cost of debt.
Interest expense is vital to assessing an organization’s financial health. That’s why financial analysts examine an organization’s debt cost to determine its profitability, capital structure, and potential risks.
Importance of cost of debt in financial analysis
An organization’s cost of debt accurately represents its outstanding liabilities. They use much of their revenue for loan repayment when they have higher debt costs. Consequently, their profitability decreases, and they may even default on making business loan payments. Let’s look at how total interest expense helps analysts with financial analysis.
1. Profitability
The cost of capital is the weighted average of the cost of debt and cost of equity. Companies paying higher interest expenses end up reducing their net income. As a result, they can’t deliver the equity return shareholders desire. This lower rate of equity also keeps potential investors away. The higher debt cost, on the other hand, means creditors are less likely to offer additional debt.
2. Risk
The Small Business Credit Survey shows that 36% of small businesses don’t receive funding because of poor credit scores. Lenders consider a company’s existing debt and credit ratings before lending money. The more the company owes in debt, the more the risk of defaulting on payments. Since higher debt amounts result in lower credit ratings, they’re less likely to get money from future borrowers.
3. Capital structure
Organizations use a mix of debt and equity to finance business operations. Increasing liabilities show higher debt obligations, which they must pay regardless of revenue. That’s why financial analysts usually examine a company’s credit rating, debt type, loan term, and interest rates to understand its capital structure.
Equities, on the other hand, are more expensive than debt. That’s why most companies use debt to reduce their cost of capital. Balancing debt and equity is critical to maximizing profitability and reducing financial risks.
An organization’s financial health also varies depending on the different components of debt cost. Let’s review these elements to understand how they impact the total obligations.
What are the components of the cost of debt?
Four components of the cost of debt are interest rate, flotation costs, risk premium, and tax savings. These elements determine the total debt cost, including a borrower’s credit rating and debt type.
1. Interest rate is an annual percentage of the principal amount a creditor charges a lender on the outstanding loan amount. Organizations usually use loans to fund operations and buy assets, making the interest rate the cost of money. That’s why the same amount of money can be expensive when the interest rate is high and vice versa.
2. Flotation cost refers to the legal, registration, audit, and underwriting fees a business incurs while issuing new securities. Even though flotation costs are considerably less for loans, they can add to the total cost of capital in case of high loan amounts.
3. Risk premium is the higher rate of return borrowers pay lenders over and above the risk-free return rate. Investors consider risk premiums a form of compensation for their relatively risky investments. The premium amount may vary depending on the borrowing company’s financial health, overall economic outlook, and industry.
4. Tax savings refer to the interest amount a business entity shows as the deductible amount from its income while calculating income taxes.
Now that you know the different components, let’s examine how debt costs work.
Also, Read: Cash Conversion Cycle (CCC): What is it, Components, Formula and How to Calculate?
How does the cost of debt work?
The cost of debt provides organizations insights into their capital structure, which also consists of equities. For example, corporations often analyze the total interest expense before taking loans for financing operations. The debt cost helps them assess whether taking debt to propel income growth makes sense.
Let’s consider a sporting goods retailer with shops across multiple states. Since they have a low cost of debt, they can consider taking out a mortgage to open a shop in a state where the potential income opportunity is twice the debt. A business with high debt cost may be unable to make a similar decision because its cash flow statement shows massive liabilities.
Investors and lenders, on the other hand, use the debt cost value to evaluate an organization’s ability to repay loans. They consider companies with higher debt costs to be more riskier and vice versa.
Cost of debt formula
Calculating the cost of debt is extremely important for enterprises looking to determine the weighted average interest rate. They can’t simply consider the average interest rate because it doesn’t accurately portray the financial repercussions of higher loan amounts.
Once you know the annual interest rate of different company debts, you can use the following formula to find the cost of debt.
Interest rate = Total interest expense / total debt balance
Business owners multiply the total interest rate by one minus their companies’ tax rate to calculate the cost of debt. The tax rate here is the amount a company pays for state and federal taxes.
Cost of debt = Total interest rate x (1 – total tax rate)
This cost of debt formula helps you find the interest rate you pay after taxes. It considers three factors, i.e., economic fluctuations, a company’s credit rating, and debt usage. Organizations with lower credit ratings will pay higher interest and vice versa.
Organizations can also find the cost of debt by summing interest rate, flotation cost, and risk premium. Now, let’s see when you should be using this formula.
When to use the cost of debt formula?
Enterprises usually use the cost of debt formula to track the cost of debt financing. The formula helps them to determine the borrowing cost and gain insights into the percentage of capital cost coming from loans and bonds.
Some companies also use the debt cost formula to track and manage the cost of existing debts. The total cost of debt aids them in forecasting cash flow and negotiating better terms with future lenders.
Investors use the formula to calculate the net present value (NPV) before financing companies. NPV tells them the difference between a company’s cash inflow and outflow value.
Learn more: What is Prime Cost? Formulas, Calculations and Applications
How to calculate the cost of debt?
Business entities calculate the pre-tax cost of debt simply by dividing the total interest by total debt.
Pre-tax cost of debt = Total interest / total debt
You can also calculate it by following the steps below:
- Calculate the total interest by multiplying all loans by their respective interest rates. Add these numbers to get the total interest.
- Sum all loans to calculate the total debt.
- Find the debt cost by dividing the total interest by the total debt.
This pre-tax debt cost is also the weighted average interest rate. It’s also crucial for calculating the weighted average cost of capital (WACC).
Businesses use the following formula to calculate the cost of debt after tax.
After-tax cost of debt = Effective interest rate x (1-total tax rate)
Calculate the debt cost after tax using the steps below:
- Deduct the tax rate from one.
- Multiply the difference by the weighted average interest rate to find the after-tax debt cost.
Let’s look at a real-life example of how a business calculates the debt cost.
Cost of debt example
Let’s take the example of G&B Electronics, an electrical manufacturing company. They produce a diverse range of consumer electronic products.
Currently, G&B Electronics has two business loans:
- INR 500,000 with an annual interest rate of 6%
- INR 950,000 with a 7% yearly rate of interest
They’ll use the following steps to calculate the before-tax cost of debt.
- Total interest = (INR 500,000 x 6%) + (INR 950,000 x 7%) = INR 30,000 + INR 66,500 = INR 96,500
- Total debt = INR 500,000 + INR 950,000 = INR 1,450,000
- Pre-tax cost of debt = INR 96,500 / INR 1,450,000 = 6.65%
Their weighted average interest rate is 6.65%. Imagine G&B Electronics paid 20% tax on their company earnings.
Now, here’s how they’ll calculate the after-tax cost of debt.
- Effective interest rate = 6.65%
- After-tax debt cost = 6.65 x (1-20%) = 5.32%
Assuming that G&B Electronics has simple interest-only debts, their cost of debt after tax is 5.32%.
Determining the after-tax cost of debt
The after-tax cost of debt refers to the interest an organization pays on debts after deducting income tax savings. Start by subtracting a company’s effective tax rate from one. Multiply the difference by the effective interest rate to calculate the after-tax debt cost.
Imagine G&B Electronics has received a bond with a 6% interest rate as debt. In this case, their pre-tax debt cost stands at 6%. Let’s say their income tax rate is 20%. Deducting 20% from 100% gives you 80%. Now, they’ll multiply 6% by 80% to find the after-tax cost of debt, which is 4.8%. As you can see, G&B Electronics calculates the after-tax cost after deducting tax savings, which it gets because of claiming debt interest as a business expense.
How do taxes impact the cost of debt?
Most countries require enterprises to pay income tax after deducting interest payments on loans and bonds. This tax-deductible loan interest reduces their taxable income and total cost of debt. As a result, higher interest rates result in increased tax savings and lower after-tax cost of debt.
Let’s take the example of G&B Electronics. They have borrowed INR 400,000 at an interest rate of 10%. Their income tax rate is 20%. The interest they’ll have to pay equals INR 40,000. Because loan interest is deductible, they can deduct 20% of INR 40,000, i.e., INR 8,000, while paying taxes. So, their post-tax debt cost is INR 392,000.
When the interest rate increases to 20%, their total interest expense equals INR 80,000. Their tax savings have grown to INR 16,000 (20% of INR 80,000). Their after-tax debt cost equals INR 384,000. This example shows how an organization’s post-tax debt cost reduces when the interest rate increases.
Now, let’s look at the factors influencing the total debt cost.
Factors influencing the cost of debt
Factors like payback period, credit ratings of the borrowing entity, interest rate, and the company’s financial health play a significant role in determining the cost of debt.
- Credit rating measures an organization’s loan repayment ability based on its credit history. Companies with lower credit rates pay more interest, resulting in higher debt costs.
- Debt term is the period a company has to repay its debts. Lenders usually charge higher interest rates for longer debt terms.
- Interest rate is a percentage of the loan a borrower charges a company for a corporate debt. The interest rate varies depending on different factors, including an entity’s credit history.
- The financial health of an organization is equally important. Companies with stronger income statements can receive debts at lower interest rates.
- Debt type also influences an organization’s total debt cost. For example, lenders often charge less interest on secured debts with collateral than unsecured ones.
Other factors include the industry a company operates in, overall economic stability, and regulatory guidelines. While these considerations significantly affect the total interest expense, companies follow different methods to keep the total cost under control.
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How to reduce the cost of debt?
Reducing the total debt cost is vital for organizations looking to boost revenue and minimize operating expenses (OpEx). They typically rely on the following ways to reduce the total interest expense.
1. Negotiate a lower interest rate
Enterprise finance teams don’t necessarily need to accept the default interest rate while taking new debts. They can always negotiate with the lender for a better rate. Successful negotiators use their organizations’ cash flow analysis to convince creditors that their company has solid financial health. You can also make the minimum payment early on, get a guarantor to co-sign for a loan, or show business assets as collateral to reduce interest rates.
2. Repay debt sooner
Paying more installments than the actual monthly amount is another effective way to reduce the debt cost. Organizations following this method reduce their principal balance, resulting in lower interest expense over a period. Some creditors may charge you exit fees when you repay a loan fully before the estimated period. Consider negotiating the repayment terms beforehand to avoid such issues in the future.
3. Improve credit score
The credit score is critical in determining the interest rate a creditor charges you. Having a lower credit rating results in companies paying higher interest rates. That’s why organizations must pay existing debts on time and use fewer credits when possible. Also, consider checking credit reports regularly to find potential credit score errors.
4. Refinance business loans
Refinancing aids an organization in repaying existing loans with a new business loan. Business owners use this method when the current interest rate is lower than the rate of their existing loans. As a result, the total interest expense decreases. Consider legal fees, credit check charges, and loan preclosure costs while calculating whether refinancing is suitable.
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Difference between cost of debt and cost of equity
The cost of debt is the total interest amount an organization pays on its liabilities, like loans and bonds. Businesses typically calculate the after-tax rate since the interest they pay is tax deductible.
The cost of equity is the rate of return or valuation shareholders expect from a company when a capital investment meets return requirements. Organizations calculate the cost of equity using the dividend capitalization model or the capital assets pricing model (CAPM).
You can calculate the cost of equity using the formula below:
CoE = rf+ βa (rm – rf)
Where:
- rf is the risk-free rate of return, which is theoretically the return rate on an investment with zero risk.
- βa or beta measures the risk by evaluating how a company’s stock price reacts to market volatility.
(rm – rf) is the difference between the market return rate and the risk-free return rate. It reveals the actual return rate investors expect above the risk-free rate.
Cost of debt | Cost of equity | |
| Meaning | The debt cost is the total interest expense an organization pays on its liabilities. | Cost of equity is the return rate investors or shareholders expect from their investment equities and securities in a company. |
| Calculation model | There’s no model associated with debt cost calculation. | Equity capital cost calculation follows the capital assets pricing model. |
| Interest rate | Lenders predetermine the interest rate while financing a company. | There’s no interest rate involved. |
| Return rate | The interest rate is the return debt holders or bondholders expect after investing in an organization. | Cost of equity is the return rate investors ask before investing in companies. |
| Formula | Effective interest rate x (1-total tax rate) | Risk-free return rate + beta (market return rate – risk-free return rate) |
Read more: Capital Budgeting: What is it, Types, Methods, Process & Examples
Cost of debt vs. annual percentage rate (APR)
An annual percentage rate or APR broadly measures an organization’s total cost of borrowing money based on interest rates, broker fees, and other charges. That’s why APR is usually higher than the actual interest rate.
APR = [{(Interest + fees)/n} x 365] x 100
It’s expressed as a percentage that reveals the actual cost a company pays for the money it borrows. However, APR doesn’t consider compounding. Organizations use APR to find a number that they can use to compare offers from different lenders.
On the other hand, the cost of debt is the effective interest rate an organization pays on loans and bonds. Unlike APR, it doesn’t include legal fees and broker charges.
After-tax cost of debt = Effective interest rate x (1-total tax rate)
Business owners consider the after-tax amount because of the tax-deductible nature of the interest they pay on loans.
Advantages of cost of debt
Businesses prefer debt over equities because debt cost is usually lower than the total equity cost. Moreover, they get to keep ownership, avail of tax deductions, and build business credit.
- Business ownership: Debt financing enables organizations to obtain funds without sacrificing ownership or equity shares. As a result, they get to control decision-making without taking input from third parties.
- Tax deductions: Taking debt also allows companies to avail tax deductions on the interest payment. As a result, their tax liability decreases, resulting in improved cash flow.
- Build business credit: Small businesses with less working capital also use debt to build their credit ratings. Consequently, they don’t have to rely on other business financing options or personal credit cards in the future. Strong business credit also helps enterprises negotiate favorable terms with vendors.
Despite these benefits, the cost of debt has its disadvantages, too.
Limitations of cost of debt
While debt fuels business growth, companies must repay the lender, regardless of the financial status of their business. Moreover, loan interest rates can be higher and may only be approved with collaterals. Consider assessing these limitations before opting for debt financing.
- Loan repayment: Organizations must honor loan repayment obligations even if they go out of business. Lenders may even foreclose the loan by selling collateral in case of secured loans.
- Credit qualification: Obtaining loans can be challenging, especially for organizations without strong credit history. Some lenders may also require companies to meet a certain revenue threshold to be eligible for loans.
- Collateral: Most institutional lenders or loan providers ask for collateral like plots, buildings, property, or equipment to minimize risks. These collateral items act as a source of loan repayment in case an organization can’t pay back the lender on time.
- Interest rate: While the interest rate depends on multiple factors, some lenders may not use methods like APR to disclose the actual loan cost. Consider asking basics like repayment terms, interest rate, and APR before obtaining a loan.
Quick read: Variable Cost: Definition, Types, Formulas, Calculations and Examples
Conclusion
Debt financing is an excellent way for businesses to obtain capital and finance operations with loans and bonds. Moreover, debt not only helps them to raise funds without diluting ownership but also to benefit from tax-deductible interest.
However, depending on their credit ratings and other factors, they may have to pay high interest. The total debt cost helps an organization budget and analyze the cash outflow for loan interest. Lenders assess an organization’s total interest expense to assess its chances of defaulting on loans.
Consider weighing the pros and cons before pursuing debt financing instead of other options.
FAQs
Equity investors often require a higher return rate than the interest companies typically pay for loans and bonds. Also, businesses prefer debt obligations instead of diluting equity ownership. That’s why debt cost is lower than equity.
You can calculate the cost of debt by deducting the total tax rate from one and multiplying the difference by the effective interest rate.
Cost of debt = Effective interest rate x (1-total tax rate)
To calculate the cost of equity, you’ll need to find the difference between market return rate and risk-free return rate. Multiply the difference by beta and add the risk-free return rate to find the equity cost.
Cost of equity = Risk-free return rate + beta (market return rate – risk-free return rate)
The debt cost is the total interest amount an organization pays creditors for loans and debt. Interest is a predetermined annualized percentage of the principal that a borrower agrees to pay the lender.
There are two types of debt cost: pre-tax and after-tax. Pre-tax debt cost calculates the total interest expense before deducting taxes. After-tax debt cost is the effective interest that you get after paying taxes.
A company securing a loan at a low interest rate can take a high amount of debt without worrying about sacrificing equity ownership shares. As a result, they don’t have to dilute equity. Consequently, their working capital can rely more on debt, which is less than the cost of equity.
The weighted average cost of capital considers a company’s cost of debt and the current market value of its debt. Companies with higher debt costs require more capital to run fund operations. Moreover, they struggle with balance sheet complexity because of varying debts and interest rates.
Companies can reduce and manage their total debt cost by negotiating lower interest rates while obtaining funds, repaying existing loans sooner, and refinancing business loans. They should also consider improving credit ratings to get loans at lower interest rates.
Regulatory bodies in every country set a benchmark interest rate based on economic climate and other factors. The total debt cost can increase or decrease when these interest rates fluctuate. Rising interest rates result in a higher cost of borrowing. When the interest rate falls, it becomes more affordable to avail loans.
Depending on the lending institutions ‘ flexibility and openness, companies can renegotiate interest rates or create new payment plans. Refinancing is an excellent option for companies looking to reduce debt costs and foreclose loans. However, consider refinancing only when the new interest rate is lower than the previous loan rate.
A company’s credit rating significantly impacts the loan interest rate and the total debt cost. A higher credit rating results in less interest, resulting in less cost of debt and vice versa.
No. The cost of debt is the total interest amount an organization owes to creditors for different loans and bonds. The interest rate is an annualized percentage of debt that a creditor charges a borrower.
Investors analyze the cost of debt to evaluate a company’s capital structure and profitability. Debt cost figures also tell them about investment risks. For example, a company not making enough profits and with too many loans may not have sufficient capital to repay new loans it obtains.
Two standard debt restructuring options are debt rescheduling and debt forgiveness. Debt rescheduling enables companies to modify maturity date, payment schedule, interest rate, or debt currency without reducing the principal amount. Partial or complete debt forgiveness occurs when a lender forgives a part or the entire debt you took.
Yes, loan repayments are tax-deductible business expenses. That’s why companies often use debt financing to reduce their net tax obligations.
Companies with high debt costs often struggle with creditworthiness. As a result, they may not be eligible for loans in the future. Moreover, creditors and investors believe these companies may default or go bankrupt.
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