Cost of Debt Formula How to Calculate it with Examples?

Business owners can deduct any paid interest on taxes at the end of the year as a business expense. You don’t have to claim this deduction as a business owner, but every little bit adds up. Interest payments are tax deductible, which means that every extra dollar you pay in interest actually lowers your taxable income by a dollar.

Because your tax rate is 40%, that means you end up paying $40 less in taxes. The best business loans are those that offer low rates, but if your personal or business credit scores aren’t high, you may not qualify for those lower interest costs. Suppose a company named AIM Marketing has taken a loan for business expansion of $500,000 at the rate of interest of 8%. The tax rate applicable was 30%; here, we have to calculate the after-tax cost of debt. In this guide, you will learn about the cost of debt, as well as how to calculate it before and after taxes have been paid.

Understanding WACC (Weighted Average Cost of Capital)

Conversely, as the organization’s profits increase, it will be subject to a higher tax rate, so its after-tax cost of debt will decline. For example, let’s say your friend offers you a $1,000 loan at 10% interest, and your company’s tax rate is 40%. The effective pre-tax interest rate your business is paying to service all its debts is 5.3%. Susan Guillory is an intuitive business coach and content magic maker. She’s written several business books and has been published on sites including Forbes, AllBusiness, and SoFi. She writes about business and personal credit, financial strategies, loans, and credit cards.

Much of this information can be found in local libraries in such publications as Moody’s Company Data; Standard & Poor’s Descriptions, The Outlook, and Bond Guide; and Value Line’s Investment Survey. The cost of debt is the after-tax effective rate paid by a borrower on its debt. 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.

Gather Data

Β measures the volatility of an investment with respect to the whole market. As the total market is assumed to have a β equal to 1, a stock whose return varies less than the ones of the market have a beta lower than 1. On the contrary, a stock whose return varies more than the returns of the market has a beta larger than 1. Id⁎ is the cost of debt capital netted by the benefit of debt leverage. The weights used for estimation of cost of capital are the market value weights of equity and book value weight of debt.

He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. In this example we have a total current (€ 14,500) and non-current (€ 5,100) liabilities of € 19,600.

How the Cost of Debt Works

The what is another word for ‘best practice’ is a critical measure because it directly impacts a company’s profitability and cash flow. A high debt cost also indicates a higher level of financial risk for a company. The cost of debt is the minimum rate of return that the debt holder will accept for the risk taken. The cost of debt is the effective interest rate the company pays on its current liabilities to the creditor and debt holders. The after-tax cost of debt generally refers to the difference between the before-tax cost of debt and the after-tax cost of debt, which is dependent on the fact that interest expenses are deductible. It is an integral part of WACC, i.e., average weight cost of capital.

For nonrated firms, the analyst may estimate the pretax cost of debt for an individual firm by comparing debt-to-equity ratios, interest coverage ratios, and operating margins with those of similar rated firms. Alternatively, the analyst may use the firm’s actual interest expense as a percent of total debt outstanding. Some analysts prefer to use the average yield to maturity of the firm’s outstanding bonds.

What’s the difference between debt financing and equity financing?

To calculate cost of debt after your interest-based tax break, multiply your effective interest rate by your effective tax rate subtracted from one. The lower your interest rates, the lower your company’s cost of debt will be — you want the lowest cost of debt possible. For example, if a company’s only debt is a bond that it has issued with a 5% rate, then its pretax cost of debt is 5%. If its effective tax rate is 30%, then the difference between 100% and 30% is 70%, and 70% of the 5% is 3.5%.

Default risk is the likelihood the firm will fail to repay interest and principal when required. Interest paid by the firm on its current debt can be used as an estimate of the current cost of debt if nothing has changed since the firm last borrowed. Exhibit 18.6 illustrates the calculation of WACC in cross-border transactions.

Therefore, it is important to take the time to do some careful research before you seek financing and find the right balance that works for you. Next, assuming the loans above all have fixed interest rates, you would calculate the total annual interest expense as follows. You may have to estimate some of the figures above, since the debt your business carries throughout the year may fluctuate. This may be especially true if you have business lines of credit or business credit cards with revolving balances.

When this kind of debt is kept at a manageable level, a company can retain more of its profits through additional tax savings. For investment grade bonds, the difference between the expected rate of return and the promised rate of return is small. The promised rate of return assumes that the interest and principal are paid on time. The cost of debt refers to the effective interest rate paid on the company’s total debt. This value is usually an estimate, particularly if calculated using averages. The amount paid in interest expenses varies from item to item and is subject to fluctuations over time.