Understanding Cost of Debt: Definition, Formula and Example

Organizations can understand how much money they make and owe others by using a variety of values. The cost of debt is one metric that many companies use. You can manage a company’s finances and be more accountable for company budgets if you have an understanding of the cost of debt.

To help you understand, we go over the definition of the cost of debt and how it’s calculated in this article, along with a calculation example.

Understanding Cost of Debt: Definition, Formula and Example

What is the cost of debt?

The interest rate a company pays on its debt is known as the cost of debt. All amounts owed, including the total amount of bonds and business loans, are included in the price of debt. This figure is helpful as it provides a good indication of a company’s financial health, particularly when compared to the total amount of debt.

The amount of debt remaining after taxes is usually referred to as the “cost of debt.” The cost of debt after taxes is lower than the cost of debt before taxes because interest expenses are tax deductible.

How does the cost of debt work?

The capital structure of a business is comprised of the costs associated with debt and equity. To finance their ongoing operations effectively, as well as any expansion plans, companies are aware of their cost of debt and cost of equity. Any business’s cost of debt is typically less than its cost of equity.

The cost of debt is of interest to more people than just professionals and business owners who are worried about their companies’ finances. This value is also considered by investors and lenders when deciding whether to fund an organization. Companies with higher debt costs are considered riskier than those with lower debt costs.

Business decision-makers weigh the cost of debt as well as the potential for income growth before taking on new debt. For instance, a company with a low cost of debt might decide it makes sense to borrow $1.5 million to open a retail location in a different state if it anticipates that the branch will generate twice as much revenue in its first year of operation. High-cost debt businesses might postpone this kind of expansion until after they pay off their debt and increase cash flow.

How to calculate the cost of debt

Businesses take note of the annual interest rate on all of their debts in order to determine the cost of their debt. Instead of just calculating the average interest rate, it’s crucial to take into account the cost of debt since, even with a lower interest rate, a larger loan will ultimately cost a business more in the long run than a smaller one. To determine the cost of debt, compute practical interest as follows:

Effective interest rate = (Total interest expense) / (Total debt balance)

Multiplying the effective interest rate by one less than the company’s tax rate is necessary since the cost of debt typically refers to an interest rate after taxes. The total amount of taxes paid by the business, including both federal and state taxes, is known as its tax rate. The cost of debt is the ultimate rate that is determined:

Cost of debt = (Total interest rate) x (1 – total tax rate)

Cost of debt example

Below is an example of finding the cost of debt:

Modify Your Locations There are two business loans available to Clothing Boutique: a $400,000 business loan with an annual interest rate of 4% and a $1 million mortgage with a 5% interest rate. The owners of the clothing boutique calculated their cost of debt using the following formulas.

To get a total interest rate of 9%, they first added 5% and 4% together. They then multiplied each loan’s balance by the interest rate. $1 million multiplied by 0.05 is $50,000. $16,000 is equal to $400,000 times 0.04. Subsequently, they contributed $50,000 and $16,000 in total, resulting in a $66,000 per-weight loan factor.

The weighted average interest rate of 4.71% was then calculated by dividing $66,000 by the total amount owed, or $1.4 million. Lastly, Change Your Spots Clothing Boutique paid a total of 25% in company taxes, which included 20% federal tax and 5% state tax.

The weighted average interest rate was multiplied by one, deducting the company tax. 4.71% * (1–25%), resulting in a 3.53% cost of debt. Be aware that Simple Interest-Only Debts were owed by Change Your Spots Clothing Boutique. Every month, some more complicated obligations are amortised.

How to reduce the cost of debt

Many businesses strive to lower their cost of debt because it promotes business growth and increases their appeal to lenders and investors. The following advice can assist a company in reducing its debt costs:

1. Raise your credit rating.

One of the main variables affecting your interest rates is your credit score. Reducing the interest rate a business pays on any future loans can be achieved by improving credit score. Your credit score can rise by using less credit and by paying off current debt. Please make sure there are no mistakes on your credit report that could lower your score by regularly checking it.

2. Negotiate lower interest rates.

The default interest rate on new debt is not something you have to accept. Some lenders are flexible, while others are not. If you can convince the lender that you are a reasonable risk, your negotiating efforts might have the most excellent chance of success. This can be accomplished by obtaining a guarantor to sign the loan document or by using the company’s or your assets as collateral.

You can bargain for a lower interest rate even if the lender is unyielding on the current one. Your lender may lower the rate if you pay more than the minimum and make your instalment payments on schedule.

3. Refinance business loans

Taking out new loans to pay off your old ones is the process of refinancing business loans. If you can find new loan terms with lower interest rates, refinancing can be a smart way to lower your debt cost. Consider the cost of legal paperwork, credit checks, and other fees when you refinance. You have the option of refinancing a business loan with your current lender or one of their rivals.

4. Pay off debts sooner.

Another efficient strategy to lower your debt cost is to pay off debts more quickly. Specific lenders permit you to accelerate loan closure and make additional payments without incurring penalties. Some impose exit fees if you pay off a loan before the agreed-upon terms are fulfilled. By renegotiating the duration of your loan repayment, you may be able to avoid exit fees.

5 Jobs that calculate the cost of debt

These five positions should be taken into consideration if you’re interested in working in finance and calculating an organization’s cost of debt:

  • Accountant
  • Bookkeeper
  • Budget analyst
  • Corporate controller
  • Personal financial adviser

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