Cost of Debt

Cost of debt refers to the effective rate a company pays on its current debt. In most cases, this phrase refers to after-tax cost of debt, but it also means the company's cost of debt before taking taxes into account. The difference in cost of debt before and after taxes lies in the fact that interest expenses are deductible.

Cost of debt is one part of a company's capital structure, which also includes the cost of equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans, among other types.

The cost of debt measure is helpful in understanding the overall rate being paid by a company to use these types of debt financing. The measure can also give investors an idea of the company's risk level compared to others because riskier companies generally have a higher cost of debt.

To calculate cost of debt, a company must determine the total amount of interest it is paying on each of its debts for the year. Then it divides this number by the total of all of its debt. The quotient is its cost of debt.

For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. It has also issued bonds worth $2 million at a 7% rate. The interest on the first two loans is $50,000 and $12,000, respectively, and the interest on the bonds equates to $140,000. The total interest for the year is $202,000. As the total debt is $3.2 million, the company's cost of debt is 6.31%.

To calculate after-tax cost of debt, subtract a company's effective tax rate from 1, and multiply the difference by its cost of debt. Do not use the company's marginal tax rate; rather, add together the company's state and federal tax rate to ascertain its effective tax rate.

For example, if a company's only debt is a bond it has issued with a 5% rate, its pre-tax cost of debt is 5%. If its tax rate is 40%, the difference between 100% and 40% is 60%, and 60% of 5% is 3%. The after-tax cost of debt is 3%.

The rationale behind this calculation is based on the tax savings the company receives from claiming its interest as a business expense. To continue with the above example, imagine the company has issued $100,000 in bonds at a 5% rate. Its annual interest payments are $5,000. It claims this amount as an expense, and this lowers the company's income on paper by $5,000. As the company pays a 40% tax rate, it saves $2,000 in taxes by writing off its interest. As a result, the company only pays $3,000 on its debt. This equates to a 3% interest rate on its debt.