Choosing the best way to borrow capital for your business is a unique challenge. It’s important to understand the options available to you when risking the future of your business and your personal livelihood.
Understanding the Cost of Debt
Calculating the total cost of debt is a key variable for investors assessing a company’s financial situation. The interest rate that the company pays on its debts will determine the long-term cost of any business loan, bond, mortgage, or other debts that the company uses for growth.
Most companies strategically use debt in order to preserve capital that will fund growth and future opportunities. While having any debt is generally not a bad thing for a company, being over-leveraged or having high-interest debt can harm the financial position of the company.
An employer seeking financing can look at the interest rates being paid by other companies in the same industry to get an idea of the potential costs of a particular loan for their company.
Calculating the Cost of Debt
The cost of debt is not necessarily just the cost of the company’s loans, although it is an important variable in the calculation. Since the interest on debt is tax-deductible, the company should multiply the coupon rate (the yield paid by a fixed-income security) on the company’s bonds by (1 – tax rate):
After-tax cost of debt = Coupon rate on bonds × (1 – Tax rate)
Example of calculating the cost of debt
For example, let’s assume a company with a corporate tax rate of 40% borrows $50,000 at an interest rate of 5%. The after-tax cost of debt is 3% (Cost of debt = 0.05 × (1 – 0.40) = 0.03 or 3%). The interest paid of $2,500 reduces the company’s taxable income, resulting in a lower net cost of capital for the company. The annual cost of capital for the $50,000 company is $1,500 (50,000 × 3% = $1,500).
Marketing costs or debt issuance costs are not considered in the calculation as those costs are typically negligible. Usually, confirm your tax rate since the interest is tax-deductible. It is also possible (and sometimes beneficial) to calculate the cost of debt before taxes:
Pre-tax cost of debt = Coupon rate on bonds
The cost of debt reflects the level of risk. If your company is considered at higher risk of defaulting on its debts, lenders will set a higher interest rate for the loan, thus increasing the overall cost of debt.
Using Debt or Alternatives to Raise Capital
Debt financing tends to be the preferred means of raising capital for many companies, but there are other ways to raise funds such as equity financing. Specific forms of alternative financing (and components of the company’s capital structure) include preferred stock, retained earnings, and new common stock.
Traditional financial wisdom recommends that companies establish a balance between equity and debt financing. It is important to choose the options that are most suitable for your employees, shareholders, and current customers.
Frequently Asked Questions (FAQs)
What is the formula for calculating the cost of debt?
The formula for calculating the cost of debt is the coupon rate on bonds × (1 – tax rate).
What is the difference between debt financing and equity financing?
In debt financing, one company borrows money and pays interest to the lender for it. In equity financing, the company sells a part of the company. Debt financing is much more common than equity financing.
Source: https://www.thebalancemoney.com/how-to-calculate-the-cost-of-debt-capital-393134
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