Cost of Debt – What it Is & How to Calculate [Formula]

The cost of debt is the rate of interest that a company pays on its outstanding debt.

The cost of debt is used in weighted average cost of capital (WACC) calculations for valuation purposes, which makes it important in everyday finance and market contexts.

How the Cost of Debt Works

The cost of debt is the effective rate that a company pays on its outstanding debt. The interest expense associated with debt is tax-deductible in many jurisdictions, so the after-tax cost of debt is the true cost.

There are several types of debt a company may have, including bonds, loans, and lines of credit.

The cost of debt is the weighted average of the interest rates associated with each type of debt. The weights are the percentages of total debt that each type represents.

To calculate the cost of debt, first, find the interest rate associated with each type of debt. For bonds, this is the coupon rate. For loans, it is the stated interest rate.

For lines of credit, it is the effective interest rate. Next, determine what percentage of total debt each type represents.

Finally, calculate the weighted average using the following formula:

 

Cost of Debt = (Bond Interest Rate x % of Total Debt in Bonds) + (Loan Interest Rate x % of Total Debt in Loans) + (Line of Credit Interest Rate x % of Total Debt in Lines of Credit)

 

The cost of debt is important because it is used in the weighted average cost of capital (WACC) calculation.

The WACC is the rate of return that a company must earn on its investments to satisfy its creditors, owners, and other stakeholders.

To calculate the WACC, first, find the cost of each type of capital: debt, equity, preferred stock, and other conceivable categories.

Then, determine what percentage of total capital each type represents.

Then, find the weighted average using the following formula:

 

WACC = (Cost of Debt x % of Total Capital in Debt) + (Cost of Equity x % of Total Capital in Equity) + (Cost of Preferred Stock x % of Total Capital in Preferred Stock)

 

The WACC is used to discount future cash flows in valuation analyses.

For example, if a company’s WACC is 10%, then a cash flow of $100 one year from now is worth $90 today (i.e., $100/(1+10%)).

Similarly, a cash flow of $100 two years from now is worth $81 today ($100/1.10^2).

Being a denominator term, the higher the WACC, the lower the present value of future cash flows.

 

How to Calculate the Cost of Debt

To calculate a company’s cost of debt, we first need to gather the following information:

1. The coupon rate on the company’s outstanding debt

2. The interest rate on the company’s loans

3. The effective interest rate on the company’s lines of credit

4. The percentage of total debt represented by each type of debt

As mentioned above, we use the following formula:

 

Cost of Debt = (Bond Interest Rate x % of Total Debt in Bonds) + (Loan Interest Rate x % of Total Debt in Loans) + (Line of Credit Interest Rate x % of Total Debt in Lines of Credit)

 

For example, let’s say a company has:

  • $1,000 in bonds outstanding with a coupon rate of 5%
  • $500 in loans outstanding with an interest rate of 8%, and
  • $200 in lines of credit outstanding with an effective interest rate of 10%

The company’s total debt is $1,700.

To calculate the cost of debt, we first need to calculate the interest expense for each type of debt:

  • Bond Interest Expense = $1,000 x 5% = $50
  • Loan Interest Expense = $500 x 8% = $40
  • Line of Credit Interest Expense = $200 x 10% = $20

Next, we need to calculate the percentage of total debt represented by each type of debt:

  • Bond Percent of Total Debt = $1,000/$1,700 = 58.8%
  • Loan Percent of Total Debt = $500/$1,700 = 29.4%
  • Line of Credit Percent of Total Debt = $200/$1,700 = 11.8%

Oftentimes, debt interest is tax-deductible, so that must also be taken into consideration, if necessary.

Finally, not taking into account taxes, we can calculate the cost of debt using the formula above:

 

Cost of Debt = (5% x 58.8%) + (8% x 29.4%) + (10% x 11.8%) = 6.47%

 

The company’s cost of debt is 6.47%.

The cost of debt is an important input in the weighted average cost of capital (WACC) calculation. The WACC is the rate of return that a company must earn on its investments to satisfy its creditors, owners, and other stakeholders.

To calculate the WACC, we first need to find the cost of each type of capital: debt, equity, and preferred stock.

Then, we need to determine what percentage of total capital each type represents. Finally, we can calculate the weighted average using the following formula:

 

WACC = (Cost of Debt x % of Total Capital in Debt) + (Cost of Equity x % of Total Capital in Equity) + (Cost of Preferred Stock x % of Total Capital in Preferred Stock)

 

What Is the Agency Cost of Debt?

The agency cost of debt refers to the idea that management teams are often incentivized to take actions that favor shareholders over bondholders in a company.

As a result, bondholders will often put covenants on debt in order to make sure that such actions will not be taken.

The agency cost of debt is also referred to as the “bondholder discount” because it represents the value that bondholders are giving up by not being able to fully control the company.

What Are the Types of Debt Covenants?

There are two types of debt covenants: negative and positive.

Negative covenants restrict the actions that management can take, while positive covenants require management to take certain actions.

The most common negative covenants are:

  • No additional debt: This covenant restricts the company from taking on any more debt.
  • Limited capital expenditures: This covenant limits how much the company can spend on capital expenditures.
  • Limited share repurchases: This covenant limits the company from repurchasing its own shares.
  • Minimum interest coverage: This covenant requires the company to maintain a certain level of earnings before interest and taxes (EBIT) to interest expense.

The most common positive covenants are:

  • Maintain insurance: This covenant requires the company to maintain insurance policies.
  • Adequate financial reporting: This covenant requires the company to provide bondholders with timely and accurate financial reports.

Cost of Debt

FAQs – Cost of Debt

What Makes the Cost of Debt Increase?

There are a few things that can cause the cost of debt to increase:

1. An increase in the company’s overall debt burden

2. A decrease in the company’s credit rating

3. An increase in market interest rates

An increase in the company’s overall debt burden will cause creditors to demand a higher rate of return, since they will be taking on more risk.

A decrease in the company’s credit rating will also cause creditors to demand a higher rate of return, since there is now a greater chance that the company will default on its loans.

Finally, an increase in market interest rates will also lead to a higher cost of debt, since creditors will be able to find better investments elsewhere, including in safe investments.

Why Is Debt Cheaper Than Equity?

The cost of debt is usually lower than the cost of equity for a few reasons:

1. Creditors are first in line to get paid if the company goes bankrupt, so they have less risk.

2. Debt is a tax-deductible expense, so the effective rate is lower.

3. Creditors don’t have much say in how the company is run, at least not relative to shareholders, so they can’t demand higher returns if they don’t like the way things are going.

What Is a Good Cost of Debt?

There is no definitive answer to this question, since it depends on the company’s overall financial situation and its goals.

A company with a high debt burden may be happy to get financing at any cost, even if it means paying a high interest rate. On the other hand, a company with a low debt burden may be able to get away with paying a lower interest rate.

It all depends on the circumstances.

What Is the Difference Between Nominal and Effective Interest Rates?

The nominal interest rate is the stated rate of interest, while the effective interest rate is the true rate of interest after taking into account compounding.

For example, let’s say you have a loan with a 10% nominal interest rate and monthly payments. The effective interest rate would be higher than 10%, since the 10% would be applied to the remaining balance each month, not the original amount of the loan.

The effective interest rate is the better number to use when calculating the cost of debt.

What Is the Difference Between Pre-Tax and After-Tax Interest Rates?

The pre-tax interest rate is the stated rate of interest before taxes, while the after-tax interest rate is the true rate of interest after taking taxes into account.

For example, let’s say you have a loan with a 10% pre-tax interest rate and you are in the 25% tax bracket. The after-tax interest rate would be 7.5%, since you would only be responsible for paying taxes on 75% of the interest.

The after-tax interest rate is the better number to use when calculating the cost of debt.

What Is the Difference Between Interest Rates and Yields?

Interest rates are the stated rates of return on a loan or investment, while yields are the actual rates of return after taking into market rates and performance.

Why Do Companies Issue Debt?

Companies issue debt for a variety of reasons, but the most common reason is to finance capital expenditures. Other reasons for issuing debt include refinancing existing debt, repurchasing shares, and paying dividends.

What Are the Benefits of Debt?

There are a few benefits of debt that companies can take advantage of:

  • Interest payments on debt are tax-deductible.
  • Debt is often cheaper than equity.
  • Debt can be used to finance growth.

What Are the Risks of Debt?

There are also a few risks associated with taking on debt:

  • If a company is unable to make its principal and interest payments, it may default on its debt. This can lead to the company having to declare bankruptcy.
  • A high level of debt can make a company less attractive to investors.
  • A high level of debt can also make a company more vulnerable to economic downturns.

What Is the Optimal Capital Structure?

There is no one “right” answer to this question as it depends on a variety of factors, such as the industry, the companies’ growth prospects, and the overall financial health of the company.

What Is the Difference Between Debt and Equity?

Debt is a loan that must be repaid, with interest, over a certain period of time. Equity is ownership in a company.

When a company borrows money, it is said to have “leverage”.

This means that the borrowed money can be used to finance growth or other initiatives.

However, if the company is unable to make its interest payments, it may default on its debt and be forced into bankruptcy.

What Is the Difference Between Senior Debt and Subordinated Debt?

Senior debt has priority over subordinated debt in the event of bankruptcy. This means that senior debt holders will be paid back before subordinated debt holders.

Subordinated debt is often referred to as “junk bonds”. This is because they are considered to be a higher risk than senior debt, and as a result, they typically offer higher interest rates.

Senior debt has a lower interest rate than subordinated debt. Subordinated debt is often called sub debt or junior debt.

What Is Mezzanine Debt?

Mezzanine debt is a type of subordinated debt. Mezzanine debt is often structured as a loan that often converts into equity in the event of a default.

This means that the lender will receive equity in the company if the company defaults on the loan.

 

Conclusion – Cost of Debt

The cost of debt is the effective rate that a company pays on its current debt as part of its capital structure. The cost of debt is used as a discount rate in order to present value of future cash flows.

There are several methods for calculating the cost of debt, but the most common method is the yield to maturity (YTM) method. The YTM method assumes that the bond will be held to maturity and that all interest payments will be made on time.

The cost of debt is important because it is used in the weighted average cost of capital (WACC) calculation. The WACC is the minimum rate of return that a company must earn on its investments in order to create value for stakeholders collectively.

The cost of debt is also important because it can be used to compare the relative cost of different types of debt financing. For example, a company may compare the cost of debt from a bank loan to the cost of debt from a bond issue.

There are several factors that affect the cost of debt, including the type of interest rate (fixed or floating), the term of the loan, and the creditworthiness of the borrower.

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