Cost of Debt

Cost of Debt

The cost of debt refers to the effective rate that a company pays on its borrowed funds. It represents the compensation that lenders demand for providing Capital to the business and is typically expressed as an annual percentage rate (APR). The cost of debt can be calculated before or after tax adjustments, as interest expenses are tax-deductible, affecting the net cost to the company.

Calculation

The cost of debt can be calculated using the following formula:

Cost of Debt = Interest Expense / Total Debt

For tax-adjusted cost of debt:

After-Tax Cost of Debt = Cost of Debt × (1 – Tax Rate)

Examples

  • Example 1: A company has a total debt of $1,000,000 and pays an annual interest expense of $50,000. The cost of debt is:
    • Cost of Debt = $50,000 / $1,000,000 = 5%
  • Example 2: If the company has a tax rate of 30%, the after-tax cost of debt would be:
    • After-Tax Cost of Debt = 5% × (1 – 0.30) = 3.5%

Cases

Understanding the cost of debt is essential for financial decision-making:

  • Case 1: A startup seeking funding must evaluate the cost of debt to determine if it can afford the interest payments.
  • Case 2: An established firm may use its cost of debt to compare financing Options between issuing Bonds and taking a bank loan.