Whether you finance your business through debt or equity measures, you must pay for the use of funds. Exactly how much is called your cost of debt.
To calculate your cost of debt, there are a couple of different formulas you need to know. Here’s what they mean and how to use them.
What Is Cost of Debt?
Cost of debt refers to the total interest your company will pay if you finance your business through a debt instrument such as a loan, mortgage, lease, bond or note. This cost is expressed as an interest rate.
Knowing this interest rate, along with the total amount of the debt owed at that rate, can help you evaluate your company’s financial health. When your cost of debt is added to your cost of equity (how much you owe your company’s investors), the result is called your cost of capital. Your cost of capital represents the total it costs you to raise capital funds for your business.
Your cost of debt can tell you how taking out a loan or pursuing an investor will affect your company’s finances. This number can help you determine whether the debt or equity opportunity makes sense for your business. It can also help financing providers evaluate your ability to repay debt.
The components of cost of debt include two major items: your interest rate and your tax rate.
Cost of Debt Interest Rate
One thing you need to know to determine your cost of debt is the interest rate you pay on your debt.
Many lenders quote an annual percentage rate (APR). Though you can use APR when calculating your cost of debt, using your effective interest rate is a more accurate method. Your effective annual interest rate takes into account the number of times the debt is compounded during the year and the costs associated with that.
Since interest on business loans can be tax-deductible, cost of debt is normally calculated after taxes are factored in. As a result, you also need to know your tax rate to calculate your cost of debt.
This tax rate figure can reflect your federal tax rate, or to be more accurate, an average of your federal, state and local tax rates. Your results will differ depending on whether you use your effective tax rate or marginal tax rate.
Effective Tax Rate vs. Marginal Tax Rate
Your effective tax rate is the total amount of federal income tax you pay as a percentage of your total income. For example, if you earned $1 million last year and paid $100,000 in federal income tax, your effective tax rate was 10%.
Your marginal tax rate is the rate applied to the last dollar of your income. If you earned $1 million, your marginal tax rate is 37%. However, you don’t pay that percentage on your entire taxes. You only pay that rate for the amount of money over that bracket’s minimum.
How to Calculate Cost of Debt
To figure out your cost of debt formula in Excel or with a cost of debt calculator, there are several different formulas you can use. Two of the most common are the after-tax cost of debt and the yield-to-maturity cost of debt formula.
The After-Tax Cost of Debt Formula
In its simplest form, the after-tax cost of debt formula calculates cost of debt (COD) by multiplying your effective interest rate (EIR) by the quantity of 1 minus your effective tax rate (ETR):
COD = EIR * (1 – ETR)
To calculate EIR for this formula, you take your total interest (TI) for the given time period from your income statement (usually annual, or you can multiply the interest on a quarterly income statement by 4, for instance), divide it by your total debt obligations (TD) from your balance sheet and multiply the result by 100 to convert the result from a decimal into a percentage rate:
EIR = (TI / TD) * 100
If you have more than one debt instrument, you will need to sum your TI from each of your debts to use this formula.
Your EIR result would be your raw cost of debt if you were not taking your taxes into account. However, since the after-tax formula factors in your taxes, you need to perform the additional step of multiplying your EIR by the quantity of 1 minus your ETR. To get ETR, divide your company’s total tax expense (TT) by your earnings before taxes (EBT):
ETR =TT / EBT
Once you know your EIR and your ETR, you can use the formula to calculate COD for cost of debt. If you want to use your marginal tax rate instead of your effective tax rate, you can substitute this into the formula.
Note that this is a simple version of the formula, and it can become more complex when dealing with multiple instruments and compounding. A cost of debt calculator or an accountant can assist you with more complex calculations.
To illustrate how the formula works, let’s assume that you paid $2,000 in interest last year, you had a total debt of $50,000, you paid a total of $30,000 in taxes, and your earnings before taxes was $100,000. Plugging in the numbers:
EIR = ($2,000 / $50,000) * 100 = 4
ETR = ($30,000 / $100,000) = 0.3
COD = 4 * (1 – 0.3) = 4 * (0.7) = 2.8
Therefore, your cost of debt rate would be 2.8%.
The Cost of Debt Yield-to-Maturity (YTM) Formula
The yield-to-maturity cost of debt formula is used when your debt instrument is a bond and you’re calculating the annual rate an investor earns if the bond is purchased today and held to maturity.
When using this version of the formula, you keep the same basic structure as the after-tax version, with the (1 – ETR) portion remaining the same. But for EIR, you substitute a special formula to calculate the interest on the bond:
P sub naught = [the sum of t = 1 to n of [PMT sub t / (1 + YTM)^t] ] + [ FV / (1 + YTM)^n ]
P sub naught = the current market price of the bond
n = number of periods remaining to maturity
FV = the future value of the bond (face value)
PMT sub t = the interest paid in period t
YTM = yield to maturity
To apply this formula using a financial calculator, you need to know the bond’s future value (face value), annual coupon rate, years to maturity, number of coupons per year and current value. Use a calculator to plug in the variables and solve for YTM. You can then substitute YTM for EIR in the after-tax formula, giving this formula:
COD = YTM * (1 – ETR)
This will give the cost of debt.
Let’s assume your company offers a 25-year 10% semi-annual bond with a face value of $100,000, selling it upon issuance at $110,000. This would yield the values:
P sub naught = $110,000
n = 25 * 2 (since the bond is semi-annual) = 50
FV = $100,000
PMT sub t = ($100,000 * 10%) / 2 = $5,000
Plugging these numbers in, we get:
$110,000 = [the sum of t = 1 to n of [$5,000 / (1 + YTM)^t] ] + [$100,000 / (1 + YTM)^50 ]
Use a financial calculator to solve YTM, which in this case comes out to 8.99%. Then, similar to the after-tax formula, multiply YTM by (1 – ETR), plugging in your effective tax rate, to get your cost of debt.
Why Your Cost of Debt Matters
Knowing your cost of debt provides critical information you need to make a smart decision about a loan or another financing opportunity. It also helps you and potential investors evaluate the financial state of your business. Having this information can improve your financial planning and your ability to attract financing.
Calculate your cost of debt to get a more complete view of your cost of capital and a firmer foundation for making strategic financing decisions.