Cost of Debt

Meaning of Cost Of Debt

The return that a company provides to its debtholders and creditors is referred to as the cost of debt. They must be compensated for any risk exposure they incur as a result of lending money to a particular business enterprise. Because observable interest rates play such a significant role in quantifying the cost of debt, calculating the cost of debt is significantly easier than calculating the cost of equity. Apart from reflecting a company's default risk, the cost of debt also reflects its exposure to interest rate fluctuations in the market. Furthermore, it is an important component of determining a company's Weighted Average Cost of Capital, also known as WACC.

Cost Of Debt Formula

Pre-Tax Cost of Debt Formula

Generally speaking, the cost of debt is the interest rate that a company must pay in order to raise debt capital. This rate can be calculated by calculating the yield to maturity on debt securities (YTM).

In the bond market, the internal rate of return (IRR) is referred to as the yield to maturity (YTM), and it is a more accurate approximation of the current, updated interest rate if the company attempted to raise debt today.

As a result, the cost of debt is NOT equal to the nominal interest rate, but rather to the yield on the company's long-term debt instruments (such as bonds). When calculating the nominal interest rate on debt, it is necessary to use historical data, whereas the yield can be calculated on a current-day basis.

However, while using a market-based yield from sources such as Bloomberg is the preferred method, the pre-tax cost of debt can be calculated manually by dividing the annual interest rate by the total amount of debt owed, which is referred to as the "effective interest rate."

Pre-Tax Cost of Debt = Annual Interest Expense / Total Debt

After-Tax Cost of Debt Formula

The formula for calculating the weighted average cost of capital (WACC) makes use of the "after-tax" cost of debt in the calculation.

The reason why the pre-tax cost of debt must be tax-affected is due to the fact that interest is tax-deductible, which effectively creates a "tax shield," i.e., the interest expense reduces a company's taxable income (earnings before taxes, or EBT), which in turn reduces the company's taxable income (earnings before taxes, or EBT), as explained above.

Because the tax benefits of debt financing are accounted for in the company's discount rate inclusive of all capital providers (or the WACC), it is necessary to use net operating profits after tax (NOPAT) in the DCF calculation to avoid double-counting of earnings.

While dividends paid to common and preferred equity holders are tax-deductible, interest expense is not, and therefore does not reduce the amount of taxes paid. The difference between pre-tax and after-tax cost of debt is due to the fact that interest expense reduces the amount of taxes paid, unlike dividends paid to common and preferred equity holders.

After−Tax Cost of Debt = Pre-Tax Cost of Debt x (1 – Tax Rate)

Cost of Debt - Public vs Private Companies

Depending on whether the company is publicly traded or privately held, the method for calculating the cost of debt differs:

Companies that are publicly traded: The cost of debt should be calculated based on the yield to maturity (YTM) of the company's long-term debt. Companies that are privately held: If the company is privately held and the yield cannot be found on sources such as Bloomberg, the cost of debt can be estimated using the yield on debt of comparable companies that are subject to the same level of risk.

Pros And Cons Of Cost Of Debt

Pros

• The overall savings realized by the company are determined by the optimal debt and equity mix.

• It is an effective indicator of the adjusted rate paid by the firms and, as a result, assists in the decision-making process for debt and equity financing.

• When the cost of debt is compared to the expected growth in income as a result of the capital investment, an accurate picture of the overall returns from the funding activity can be obtained.

Cons

• The company is obligated to repay the principal amount borrowed, as well as interest accrued. The failure to meet one's financial obligations results in the imposition of penal interest on arrears.

• Other fees and charges associated with debt financing, such as credit underwriting fees and other fees, are not included in the calculations.

• The formula is predicated on the assumption that the firm's capital structure has not changed during the period under consideration.

• In order to understand the overall rate of return to debt holders, it is necessary to take into account interest expenses on creditors as well as current liabilities.