Whether you finance your business with debt or equity, 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 pays if you finance your business with debt 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 cost of capital and overall financial health.
When your cost of debt is added to your cost of equity, the result is your cost of capital. Your cost of capital represents the total cost you pay 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. It also can help you determine whether the debt or equity opportunity makes sense for your business. Further, it can help potential lenders evaluate your ability to repay debt.
The components of cost of debt include 2 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). Although 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 represents your total rate between 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 in taxes on your entire income. You only pay that rate for the amount of money you earn over that tax bracket’s minimum. In 2020, for example, you’d pay 37% in taxes for income exceeding $518,400 ($622,050 if you’re married filing jointly).
Cost of Debt Key Takeaways
- Cost of debt is the overall interest rate that your company has to pay on borrowed money.
- Because interest on business loans are tax-deductible, tax rates are often included in debt cost calculations.
- Cost of debt is a major part of your company’s overall cost of equity, which varies based on how much of your capital is debt and how much is equity.
- You can calculate the cost of debt using a simple formula. A financial calculator can also help.
How to Calculate Cost of Debt
To figure out your cost of debt in a spreadsheet 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 1 minus your effective tax rate (ETR):
COD = EIR x (1 – ETR)
To calculate EIR for this formula, you take your total interest (TI) expenses 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. This will convert the result from a decimal into a percentage rate:
EIR (as a %) = (TI / TD) x 100
If you have more than one debt instrument, you will need to sum your TI expenses from each of your debts to use this formula.
Your EIR result would be your raw cost of debt if you weren’t 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.
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.
EIR = ($2,000 / $50,000) x 100 = 4%
ETR = ($30,000 / $100,000) = 0.3
COD = 4 x (1 – 0.3) = 4 x (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 debt yield 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 = [the sum of t = 1 to n of [PMT sub t / (1 + YTM)^t] ] + [ FV / (1 + YTM)^n ]
P = 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 x (1 – ETR)
This will give the cost of debt.
Let’s assume your company offers a bond that matures in 25 years with a 10% coupon rate that’s paid out on a semi-annual basis. The face value (future value) of the bond is $100,000 and the bond price (market value) is $110,000.
Market Value = $110,000
Number of Payments = 25 * 2 (since bond payments are semi-annual) = 50
Future Value = $100,000
Payment Amount = ($100,000 x 10%) / 2 = $5,000
Plugging these numbers into the formula above, we see:
$110,000 = [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.
How to Improve Your Cost of Debt
There are a number of ways that you can lower your company’s overall cost of debt, including:
- Replace unsecured loans with secured loans
- Pay off balances on business credit cards and other high-interest financing accounts
- Refinance merchant cash advances into long-term loans
- Have investors inject equity capital that can be used to pay down debt
- Refinance short-term debts with long-term loans