Cost of Debt Formula

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 the debt holder will accept for the risk taken. The cost of debt is the effective interest rate the 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 the before-tax cost of debt and the after-tax cost of debt depends on the fact that interest expenses are deductible. It is an integral part of WACC, i.e., weight average cost of capital. The company’s capital cost is the sum of the Cost of debt plus the Cost of equity. And the cost of debt is 1 minus tax rate into interest expense.

The cost of debt formula is:-

The effective interest rate is annual interest upon total debt obligation into 100. The formula for the 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 a loan of $200,000 from a Bank at the rate of interest of 8% to issue a company bond of $200,000. Based on the loan amount and interest rate, interest expense will be $16,000, and the tax rate is 30%.

The cost of debt is calculated Using the 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

The cost of debt of the company is $11,200.

Now let’s take one more to understand the formula of interest expense and cost of debt.

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

The cost of debt is calculated Using the 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 the risk level of the company; if the debt of the company is high, then the risk associated with the company will be high based on which investor decide on investment in the company. So, the cost of debt has a significant element of tax rate and interest expense. Once the cost of debt is calculated, one can evaluate the loan by comparing the business income that the loan has generated and the 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 purposes by a company as treated as business expenses.

The after-tax cost of debt formula will be as follows:-

Now, we can see that the 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%, the tax rate applicable was 30%; here, we have to calculate the after-tax cost of debt.

Interest Expense is calculated using the below formula

Interest Expense = Loan Amount * Rate of interest

• Interest Expense= $500,000 * 8%
• Interest Expense = $40,000

The cost of debt is calculated Using the 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 the 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 an after-tax cost of debt which is $19,600.

The after-tax cost of debt is high as income tax paid by the company will be low as the company has a loan on it, and the interesting part paid by the company will be deducted from taxable income. Hence, the cost of 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 the rate of interest is 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 five years at a rate of interest of 8%; the tax rate applicable is 30%. Now, we will see amortization to calculate the cost of debt.

Amortization schedule of one year of the 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

The cost of debt is calculated using the formula

Cost of Debt = Interest Expense (1- Tax Rate)

• Cost of Debt = $3,694 * (1-30%)
• Cost of Debt = $2,586

The cost of debt is lower as a principal component of a loan keeps on decreasing; if the loan amount has been used wisely and can generate a net income of more than $2,586, then taking a loan is beneficial.

Relevance and Uses of Cost of Debt Formula

There are multiple uses of the 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 calculate the net income a company generates by using loan amounts.
• The cost of debt formula is a component of WACC, i.e., Weighted average Cost of capital.
• To know a company’s actual financial position, one can also calculate the after-tax debt cost.

Ways to Low Cost of Debt

There are many ways to reduce the low cost of debt; they are as follows:-

• Get Cheaper Loan

A 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 a loan with a rate of interest he is eligible for; then, when the business starts growing, he can refinance the 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 can afford it. The cost of debt is compared with income generated by loan amount, so increasing business income can reduce the cost of debt.

Cosdebt Debt Formula Calculator

You can use the following Cost of Debt Calculator

Conclusion

It is a tool that helps one know whether that loan is profitable for business 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 issuing bonds to buying prime machinery to generate revenue and grow business. It also helps to know the cost of capital of a company. It helps to know the actual cost of debt, and debt helps to justify the cost of debt in the business.

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