Calculate the Cost of Debt

The cost of debt is the effective rate that a company pays on its borrowed funds from financial institutions and other resources. These debts may be in the form of bonds, loans, and others. Companies can calculate either the pre-tax or after-tax cost of debt. Because interest payments are usually tax-deductible, the after-tax cost of debt is used more often. The cost of debt is useful for finding the interest rate that is most suitable for a company's financing requirements. It can also be used to measure a company's risk because high-risk companies have comparatively higher costs of debt.

Steps

Understanding Corporate Debt

1. Learn the basics of business debt. Debt is money borrowed from another party. It must be repaid at an agreed-upon date. The company borrowing the money is called the debtor or borrower. The lending institution is called the creditor or lender. Businesses borrow money with commercial or term loans or by issuing bonds.
2. Understand the meaning of commercial and term loans. Commercial banks or other lending institutions offer commercial loans. Businesses use commercial loans for a variety of reasons, including funding purchases of capital equipment, increasing the workforce, purchasing or renovating property or funding mergers and acquisitions.
   • Creditors do not have any ownership interest in the company.
   • Creditors have no voting power in the company.
   • Interest paid on the loan is tax deductible.
   • Unpaid debt is a liability.
3. Learn about the different types of corporate bonds. Businesses that need to borrow large amounts of money usually issue bonds. Investors purchase the bonds for cash. The company pays the investors back the principal plus interest.
   • The investors who purchase the bonds do not have any ownership of the company.
   • The interest paid to investors is the stated interest on the bond. This may differ from market interest rates.
   • Market interest rates may cause the value of the bond to fluctuate for investors, but they do not impact the interest rate paid by the company to the investors.

Calculating the After-tax Cost of Debt

1. Understand why the after-tax cost of debt is calculated. The interest a company pays on its debt is tax deductible. Therefore, it is more accurate to adjust for this tax savings when calculating the cost of debt. The net cost of debt equals the interest paid less the deductible amount of the interest payments. The after-tax cost of debt gives investors information about the stability of the company. Companies with a high after-tax cost of debt may be riskier investments.
2. Determine the corporate income tax rate. The federal government levies a graduated corporate income tax rate. The rate a company pays is based on its taxable income.
   • Between 2005 and 2015, businesses in the United States paid between 15 percent and 38 percent of their income in taxes. The lower tax bracket applies to the first $50,000 of earnings, with the tax rate increasing up to 35 percent as income rises. The higher tax bracket applies to businesses with higher income.
   • Personal service corporations pay a flat rate of 35 percent.
   • Some corporations may also be responsible for accumulated earnings tax of up to 20 percent for taxable income in excess of $250.000.
3. Determine the interest rate on the debt. Interest rates on corporate commercial loans depend on the size of the loan, the type of lending institution used and the type of business being funded. This information can be found in the loan documents from the lending institution. Interest rates on bonds are stated on the face of the bond.
4. Calculate the adjusted interest rate. Multiply the interest rate by 1 minus the corporate tax rate.
   • For example, suppose a company with a 35 percent income tax rate issues a bond with a 5 percent stated interest rate. The adjusted interest rate would be calculated with the equation .05 x (1 - .35) = .0325. In this example, the after-tax interest rate is 3.25 percent. The after-tax cost of debt would be calculated using the 3.25 percent adjusted interest rate.
   • In the finance industry, cost of debt is usually represented using this adjusted interest rate, rather than as a dollar amount.
5. Calculate the annual cost of debt. To calculate the annual cost of debt, multiply the after-tax interest rate of the debt by the principal amount of the debt.
   • For example, suppose the principal value of the bond is $100,000 and the adjusted after-tax interest rate is 3 percent. The annual cost of debt can be calculated with the equation $100,000 x .03 = $3,000. In this example, the annual cost of the bond issue is $3,000.

Calculating Average Cost of Debt

1. Know why to calculate average cost of debt. For many companies, especially large ones, debt financing will include more than one type of debt. At a simpler level, most companies will have different types of loans, perhaps several for vehicles and a property loan. In any cases, the costs of debts for each of these loans must be combined to find the company's total cost of debt.
   • The average cost of debt will combine the weighted costs of debt for each debt that the company owns. For accuracy, we will use the after-tax calculation, as most real-world companies use this calculation.
2. Calculate the weighted average cost of debt. In order to do this, you will need to calculate the cost of debt for each type of debt that the company owes. Use the above method for calculating after-tax cost of debt to determine each one. Then, you'll need to calculate the weighted average of these costs. That is, you'll have to average the individual costs of debt based on how much of a share of the total debt that debt source accounts for.
   • For more information on calculating weighted averages, see how to calculate weighted average.
   • For example, imagine your company had a total debt of $100,000. This was divided into a $25,000 loan and $75,000 worth of bonds with 3% and 6% after-tax costs of debt, respectively.
   • Your average cost of debt would be calculated by multiplying the cost of debt for the loan by its share of the total debt ($25,000/$100,000, or 0.25) and adding this to the cost of debt for the bonds times its share of the total debt ($75,000/$100,000, or 0.75).
   • So your average cost of debt would be 0.25*3% + 0.75*6%=0.75% + 4.5%= 5.25%.
3. Understand the uses of cost of debt. Once you know the company's average cost of debt, you can use this to analyze the company or perform further calculations. Knowing the cost of debt is useful for comparing companies.
   • A higher cost of debt is generally associated with riskier companies. Investors often look at this figure when evaluating a company.

Calculating the Pre-tax Cost of Debt

1. Understand why the pre-tax cost of debt is calculated. Knowing the before-tax cost of debt is important if the tax code changes. If the tax code changes one year to disallow a company to deduct interest payments from income taxes, that company must understand how to calculate the pre-tax cost of debt.
2. Calculate the cost of debt. The interest rate of the debt is multiplied by the principal. For example, for a $100,000 bond with a 5 percent pre-tax interest rate, the pre-tax cost of debt could be calculated with the equation $100,000 x .05 = $5,000.
   • The second method uses the after-tax adjusted interest rate and the company’s tax rate.
3. Calculate the cost of debt using the after-tax adjusted interest rate. If the company does not disclose the pre-tax interest rate of the loan, but you need that information, you can still calculate the pre-tax cost of debt. For example, suppose a company with a 40 percent income tax rate has issued a $100,000 bond with an after-tax cost of debt of $3,000.
   • Express the tax rate as a decimal using the equation 40 / 100 = .40. Subtract the tax rate from 1 using the equation 1 - .40 = .60.
   • Calculate the pre-tax cost of debt by dividing the after-tax cost of debt by the result. Use the equation $3,000 / .60 = $5,000. In this example, the pre-tax cost of debt is $5,000.
4. Calculate the pre-tax cost of debt over the life of the loan. Multiply the pre-tax cost of debt by the number of years in the life of the loan.
   • For example, suppose the company issued a 2 year bond. The total pre-tax cost of debt would be calculated by multiplying the annual cost of debt by 2. Use the equation $5,000 x 2 = $10,000. In this example, the total pre-tax cost of debt would be $10,000.

Related Articles

• Analyze Debt to Equity Ratio
• Calculate Shareholders' Equity
• Calculate Owner’s Equity
• Calculate Bond Value
• Calculate Annual Percentage Rate

Sources and Citations

See also

• Check the Balance of a Debit Card
• Turn in a Lost Credit Card
• Use a Credit Card
• Cancel a Credit Card
• Activate Your Atm Card
• Use a Credit Card Payoff Calculator
• Use a Credit Card as a Debit Card
• Use a Credit Card System
• Transfer a Visa Gift Card Balance to Your Bank Account with Square
• Add Money to PayPal

Read more ...