The cost of debt refers to how much money it costs a firm when using debt for financing. Whenever anyone takes out debt, they must repay interest on the debt. The interest rate associated with the debt then is the cost of debt, because the interest rate on the debt is how much money the firm must pay to obtain the debt.
Cost of debt is used primarily in weighted average cost of capital equations. For example, Firm A wants to start a construction project. In order to finance the construction project, Firm A must take out a $100,000 loan at a 10 percent interest rate. The cost of debt then is 10 percent because to obtain the $100,000, the firm must pay the lender an additional 10 percent. Often, companies measure cost of debt as after-tax cost of debt because interest expenses on debt are tax deductible.
Determine the interest rate a company is paying on its debt and how long the company has to pay the debt. In our example, if the company has two years to pay back the debt, then the interest rate is 10 percent and the term is two years.
Determine the effective annual interest rate by dividing the interest rate by the term, and adding one. Then, raise the sum to the power of the term. Finally, subtract one. In our example, 10 percent divided by 2 equals 0.05 and 0.5 plus 1 equals 1.5. Then, 1.5 ^ 2 equals 1.1025. Finally, 1.1025 minus 1 equals 10.25 percent. Therefore, 10.25 percent is the effective annual interest rate.
Multiply the effective annual interest rate by one minus the tax rate to determine after-tax cost of debt. In our example, Firm A's tax rate is 35 percent, so one minus the tax rate equals 65 percent. Then, 10.25 percent times 65 percent equals 6.66 percent.
- Photo Credit Calculator image by Alhazm Salemi from Fotolia.com
How to Calculate the Pre-tax Cost of a Debt
Cost of debt is what it costs a company to maintain debt. The amount of debt is normally calculated as the after-tax...
How to Calculate Cost of Capital
Companies don’t get to use the money they raise from investors for free. The cost of capital, or weighted average cost of...
How to Calculate the Cost of Equity & Debt
The cost of equity and cost of debt is a measure of how much a company needs to pay for either equity...
How to Calculate Cost of Equity and Debt for WACC
Almost all companies finance their operations with a mix of debt and equity capital. The costs associated with investment capital are reflected...
How to Calculate Weighted Cost
The weighted average cost of capital is used by business executives to calculate a firm's average cost of its financing sources. A...
How Do Interest Rates Affect the Cost of Capital?
Capital is the money invested in a business required to make the business function effectively. This capital can take many different forms,...