Cost of Debt Formula: How to Calculate It in Your Business
Knowing how to calculate the cost of debt formula is important for any business owner or manager. It helps measure the true cost of borrowing money and is essential to making sound financial decisions.
You can use the debt to help your business grow. If your debt cost is too high, it might not be worth it.
In this article, you’ll find out how to calculate your debt financing, including interest rates. We’ll also share some tips on how to reduce the cost of debt.
What is the Cost of Debt?
The cost of debt is the amount of money a company pays to borrow money. This includes the company’s loan interest rate and any fees associated with borrowing money.
Business owners often use it to determine how a new loan can increase business profits. Moreover, it helps companies identify new deductions as interest paid on business debt is tax-deductible.
You must not confuse the cost of debt with the cost of sales, the total interest your company pays on all of your debt, including loans, business credit cards, and other types of debt.
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How to Calculate the Cost of Debt?
There are two formulas you need to consider to calculate the total.
The Pre-Tax Cost of Debt Formula
The pre-tax cost of debt is the interest expense before income taxes. This can be useful for deciding what kind of loans to take out and how to structure them for maximum tax efficiency.
You can calculate it using this cost of debt equation.
Pre-Tax Cost of Debt = Annual Interest Expense / Total Debt
The debt before tax cost is important because it helps management decide whether to issue new or retire old debt.
After-Tax Cost of Debt Formula
The after-tax cost of debt formula is a calculation used to determine a company’s after-tax cost of borrowing. Also, this formula is necessary for calculating the weighted average cost of capital (WACC) and the average interest rate.
After−Tax Cost of Debt = Pre-Tax Cost of Debt x (1 – Tax Rate)
The after-tax cost of debt formula is important because it can help a company save money on its borrowing costs.
By understanding the formula, a company can compare different loans and choose the one that will save the company money in the long run.
Cost of Debt Calculation Example
The company has a bond outstanding with a face value of $1,000 and a coupon rate of 5%. The current market interest rate for similar bonds is 6%. The company’s tax rate is 35%.
You can calculate the cost of debt for this company would as follows:
Cost of Debt = Interest rate on the bond * (1 – tax rate)
= 5% * (1 – 0.35)
So, even though the market interest rate for similar bonds is 6%, the company’s cost of debt is only 3.25% after considering their tax rate.
Factors to Consider to Calculate the Cost of Debt
You should be able to get this information from your business accountant. Don’t forget that you must account for federal, state, and local taxes.
To find your company’s average income tax rate, divide your total tax liability by your total taxable business income.
The average maturity
This will give you an idea of how long you’ll need to pay off your debts and how much interest you’ll accrue over time.
The longer the average maturity, the more interest you will ultimately have to pay.
Interest expense is the total amount of interest you have to pay for your loan. This should also include any tax-deductible loan fees.
Most lenders will give you an annual percentage rate (APR) quote, which already accounts for interest and fees. Ask your lender to determine the total interest expense or use a business loan calculator.
The market value
To get the market value of your outstanding debt, you need to find the present value of all future cash flows associated with the debt using a discount rate that reflects the riskiness of your debt.
If the market value of your debt is high, investors are willing to pay more for your debt than the face value of the debt. This can lead to a lower cost of debt for your business.
Why Should I Calculate My Cost of Debt?
The benefits of learning the cost of debt formula revolve around two things: profits and taxes.
Most of what you do as a small business owner is probably to increase your business profits.
Using the cost of debt formula, you can determine whether or not taking out a new loan is worth it. If the cost of debt outweighs the expected profits, it’s probably not worth it.
Since the interest paid on business debt is deductible, the cost of debt formula can help you maximize your business tax deductions.
Lastly, when you apply for a new business loan, lenders might want to look at your debt cost before deciding whether or not to approve your application. If you have too much debt, lenders may not want to risk lending to you.
To successfully run a small business, you must stay on top of your finances. Learning how to calculate your debt and understanding what it means is one way you can determine your company’s cost for the debt.
How to Lower My Cost of Debt?
You should do a cost of debt analysis every time you consider taking out a new business loan. It’s one of the most effective ways to determine whether or not a loan is worth the cost.
If, after using the formula, you find that your business’ cost of debt is higher than it should be, here are a few ways to lower your cost of debt.
Refinancing your business loan can be a great way to lower your interest rates. If your business credit score has improved since you took out your loan, you might qualify for better rates.
Assuming your interest rate is the same either way, shorter terms result in less money paid in interest. If you can afford the higher monthly payments, a shorter term can lower your cost of debt.
Improving your business’ credit score is the best way to ensure you get low-interest rates. You can do this by making your loan payments on time, lowering your credit utilization, and more.
You can also qualify for lower interest rates by opting for a secured loan. If you have valuable personal or business assets, you can use them to secure your business loan and lower your rates.
Find the Right Lender
One of the best ways to find great interest rates is to shop around and compare prices. At Camino Financial, we offer small business loans with great rates and terms as part of our effort.
What Makes the Cost of Debt Increase?
There are a few factors that can cause the cost of debt to increase.
- A change in monetary policy from the Central Bank: if interest rates go up, so does the cost of borrowing.
- Inflation: as prices go up, the borrowed money loses value, so creditors require a higher return to compensate for this loss.
- The borrower’s riskiness: A lender may charge a higher average interest rate on new loans to a borrower with a history of default or other financial problems.
Be Smart When Acquiring Debt
Cost of debt is an essential concept that all small business owners should be familiar with. It can help you maximize your profits, identify tax deductions, and help you get a business loan.
Fortunately, the cost of debt formula is relatively simple and easy to use. By taking the time to understand how to use this formula, you can take control of your business’ finances.
If you’re having trouble finding an affordable small business loan, be sure to request a quote for a business loan from Camino Financial today!
We offer great business loans with competitive interest rates to fit any budget. We care about our borrowers and want to see them succeed!
How do you calculate the cost of debt in WACC?
The WACC, or Weighted Average Cost of Capital, represents the average cost of all the capital a firm has raised to finance its operations. This includes both equity and debt financing.
The weighting is based on the proportion of each type of financing that the company has.
Cost of debt is simply the interest rate a firm must pay on its outstanding debt. To calculate the cost of debt for WACC purposes, we use the after-tax cost of debt.
What is interest on the debt?
Interest on debt is the fee charged by a lender to a borrower for the use of borrowed money. It’s essentially a form of rent that the borrower pays to use someone else’s money.
The interest rate is determined by two factors: the amount of risk that the lender perceives and the length of time for which the money is borrowed.
Why does debt have a cost?
First, you typically pay interest on that loan when you borrow money. And, since interest compounds over time, the longer you take to pay off your debt, the more expensive it becomes.
Second, a low credit score can lead to higher interest rates and may make it more difficult to borrow money in the future. This can add up to significant costs over time.
Finally, carrying too much debt can also be stressful. Debt can weigh on your mind and cause anxiety about your finances. This stress can also lead to health problems down the road.
What is the agency cost of debt?
The agency cost of debt is the difference between the interest rate a company would pay if it had no debt and the actual interest rate the company pays on its outstanding debt.
The higher the agency’s cost of debt, the more expensive it is for a company to borrow money.
What is the difference between the cost of debt and the APR?
The debt cost is the total interest and fees you will pay on the loan. The APR, or annual percentage rate, is the yearly interest rate on loan. It’s expressed as a percentage of the principal amount.
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