Cost of Debt Formula (Table of Contents)
- Cost of Debt Formula
- Examples of Cost of Debt Formula (With Excel Template)
- Cost of Debt Formula Calculator
Cost of Debt Formula
The cost of debt is the minimum rate of return that debt holder will accept for the risk taken. Cost of debt is the effective interest rate that company pays on its current liabilities to the creditor and debt holders. Generally, it is referred to after-tax cost of debt. The difference between before-tax cost of debt and after tax cost of debt is depended on the fact that interest expenses are deductible. It is an integral part of WACC i.e. weight average cost of capital. Cost of capital of the company is the sum of the cost of debt plus cost of equity. And Cost of debt is 1 minus tax rate into interest expense.
Cost of debt formula is:-
The effective interest rate is annual interest upon total debt obligation into 100. Formula for same is below:-
Effective Interest Rate / Interest Expenses = (Annual Interest / Total Debt Obligation) * 100
Examples of Cost of Debt Formula (With Excel Template)
Let’s see an example to understand the cost of debt formula in a better manner.
Cost of Debt Formula – Example #1
A company named Viz Pvt. Ltd took loan of $200,000 from a Bank at the rate of interest of 8% to issue company bond of $200,000. Based on the loan amount and rate of interest, interest expense will be $16,000 and the tax rate is 30%.
Cost of Debt is calculated Using below formula
Cost of Debt = Interest Expense (1- Tax Rate)
- Cost of Debt = $16,000(1-30%)
- Cost of Debt = $16000(0.7)
- Cost of Debt = $11,200
Cost of debt of the company is $11,200.
Now let’s take one more to understand formula of interest expense and cost of debt.
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Cost of Debt Formula – Example #2
Suppose a company named Arts Pvt. Ltd has taken a loan from a bank of $10 million for business expansion at a rate of interest of 8%, and the tax rate is 20%. Now we will calculate the cost of debt.
Let interest is applied on principle. Assuming the interest calculation method as simple interest.
Interest Expense = Loan Amount * Rate of interest
- Interest Expense = $10,000,000 * 8%
- Interest Expense = $800,000
Cost of Debt is calculated Using below formula
Cost of Debt = Interest Expense (1- Tax Rate)
- Cost of Debt = $800,000 (1-20%)
- Cost of Debt = $800,000 (0.80)
- Cost of Debt = $640,000
Here, the cost of debt is $640,000.
The cost of debt measurement helps to find the financial condition of the company and also helps to know risk level of the company as if the debt of the company is high, then risk associated of the company will be high based on which investor take the decision of investment in the company. So, the cost of debt has a major element tax rate and interest expense. Once the cost of debt is calculated then one can evaluate loan by comparing business income that loan has generated and cost of debt. This cost of debt provides interest expense which later on helps in taxation that will be a tax deduction. This interest expense is used for tax saving purpose by a company as treated as business expenses.
After-tax cost of debt formula will be as follows:-
Now, we can see that after-tax cost of debt is one minus tax rate into the cost of debt.
Let’s see an example to understand it better.
Cost of Debt Formula – Example #3
Suppose a company named AIM Marketing has taken a loan for business expansion of $500,000 at the rate of interest of 8%, tax rate applicable was 30%, here we have to calculate after-tax cost of debt.
Interest Expense is calculated using below formula
Interest Expense = Loan Amount * Rate of interest
- Interest Expense= $500,000 * 8%
- Interest Expense = $40,000
Cost of Debt is calculated Using below formula
Cost of Debt = Interest Expense (1- Tax Rate)
- Cost of Debt = $40,000 *(1-30%)
- Cost of Debt = $40,000 *0.70
- Cost of Debt = $28,000
After Tax Cost of Debt is calculated Using below formula
After Tax Cost of Debt = Cost of Debt * (1 – Tax Rate)
- After tax cost of debt = $28,000 * (1-30%)
- After Tax Cost of Debt = $28,000* (0.70)
- After Tax Cost of Debt = $19,600
Now, we got after tax cost of debt that is $19,600.
After-tax cost of debt is very important as income tax paid by the company will be low as the company is having a loan on it and interest part paid by the company will be deducted from taxable income. Hence, the cost for debt is crucial as it gives a chance to a company to save its tax. When a company borrows money for the issuance of a bond, it is kept in mind that rate of interest shown below as the company has to give a fixed rate of interest to an investor who has invested in their company bonds.
Now, let’s see a practical example to calculate the cost of debt formula.
Cost of Debt Formula – Example #4
A company named S&M Pvt. Ltd has taken a loan of $50,000 from a financial institution for 5 years at a rate of interest of 8%, tax rate applicable is 30%. Now, we will see amortization to calculate the cost of debt.
Amortization schedule of one year of loan.
Here, we can see that interest paid by a company in one year is:-
- Interest Expenses = 333 + 329 + 324 + 320 + 315 + 310 + 306 + 301 + 296 + 291 + 287 + 282
- Interest Expenses = $3,694
Cost of Debt is calculated using formula
Cost of Debt = Interest Expense (1- Tax Rate)
- Cost of Debt = $3,694 * (1-30%)
- Cost of Debt = $2,586
Cost of debt is lower as a principal component of loan keep on decreasing, if loan amount has used wisely and able to generate net income more than $2,586 then taking loan was useful.
Relevance and Uses of Cost of Debt Formula
There are multiple uses of Cost of debt formula they are as follows:-
- Cost of debt help to save taxes.
- It helps to calculate the risk associated with the company.
- It helps one to calculate net income generated by a company by using loan amount.
- Cost of debt formula is a component of WACC i.e. Weighted average cost of capital.
- One can also calculate after-tax cost of debt to know the actual financial position of a company.
Ways to Low Cost of Debt
There are many ways to the low cost of debt, they are as follows:-
- Get Cheaper Loan
Cheaper loan means to get a loan at a lower rate of interest which can be done by creating a good credit score by repaying loans on time, offering collaterals, negotiating etc.
- Refinancing Loan
First, one needs to start loan with a rate of interest he is eligible for then when business starts growing he can refinance your loan at a lower rate after some months of the loan.
- Optimize Business Growth
With an increase in income of the business, one can avail more debt as he will be able to afford it. Cost of debt is compared with income generated by loan amount so, by increasing business income, the cost of debt can reduce.
Cost of Debt Formula Calculator
You can use the following Cost of Debt Calculator
| Interest Expense | |
| Tax Rate | |
| Cost of Debt Formula = | |
| Cost of Debt Formula = | Interest Expense x (1 - Tax Rate) |
| = | 0 x (1 - 0) = 0 |
Conclusion
Cost of debt formula is a tool which helps one to know that loan availed is profitable for business or not as we can compare the cost of debt with income generated by loan amount in business. The loan can be taken for multiple reasons from the issuance of a bond to buying of machinery prime reason for it is to generate revenue and grow business. It also helps to know the cost of capital of a business. Cost of debt formula helps to know the actual cost of debt and also helps to justify the cost of debt in business.
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