What Is the Cost of Debt?

The cost of debt is the effective interest rate that a company pays on its debts, such as bonds and loans. The cost of debt can refer to the before-tax cost of debt, which is the company’s cost of debt before taking taxes into account, or the after-tax cost of debt. The key difference in the cost of debt before and after taxes lies in the fact that interest expenses are tax-deductible.

Key Takeaways

  • The cost of debt is the effective rate that a company pays on its debt, such as bonds and loans. 
  • The key difference between the pretax cost of debt and the after-tax cost of debt is the fact that interest expense is tax-deductible.
  • Debt is one part of a company’s capital structure, with the other being equity. 
  • Calculating the cost of debt involves finding the average interest paid on all of a company’s debts. 
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Cost of Debt

How the Cost of Debt Works

Debt is one part of a company’s capital structure, which also includes 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.

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.

The cost of debt is generally lower than cost of equity.

Examples of Cost of Debt

There are a couple of different ways to calculate a company’s cost of debt, depending on the information available.

The formula (risk-free rate of return + credit spread) multiplied by (1 - tax rate) is one way to calculate the after-tax cost of debt. The risk-free rate of return is the theoretical rate of return of an investment with zero risk, most commonly associated with U.S. Treasury bonds. A credit spread is the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality.

This formula is useful because it takes into account fluctuations in the economy, as well as company-specific debt usage and credit rating. If the company has more debt or a low credit rating, then its credit spread will be higher.

For example, say the risk-free rate of return is 1.5% and the company’s credit spread is 3%. Its pretax cost of debt is 4.5%. If its tax rate is 30%, then the after-tax cost of debt is 3.15% = [(0.015 + 0.03) × (1 - 0.3)].

As an alternative way to calculate the after-tax cost of debt, a company could determine the total amount of interest that it is paying on each of its debts for the year. The interest rate that a company pays on its debts is inclusive of both the risk-free rate of return and the credit spread from the formula above because the lender(s) will take both into account when initially determining an interest rate.

Once the company has its total interest paid for the year, it divides this number by the total of all of its debt. This is the company’s average interest rate on all of its debt. The after-tax cost of debt formula is the average interest rate multiplied by (1 - tax rate).

For example, say a company has a $1 million loan with a 5% interest rate and a $200,000 loan with a 6% rate. The average interest rate, and its pretax cost of debt, is 5.17% = [($1 million × 0.05) + ($200,000 × 0.06)] ÷ $1,200,000. The company’s tax rate is 30%. Thus, its after-tax cost of debt is 3.62% = [0.0517 × (1 - 0.30)]. 

Impact of Taxes on Cost of Debt

Since interest paid on debts is often treated favorably by tax codes, the tax deductions due to outstanding debts can lower the effective cost of debt paid by a borrower. The after-tax cost of debt is the interest paid on debt less any income tax savings due to deductible interest expenses. To calculate the after-tax cost of debt, subtract a company’s effective tax rate from 1, and multiply the difference by its cost of debt. The company’s marginal tax rate is not used; rather, the company’s state and federal tax rates are added together to ascertain its effective tax rate.

For example, if a company’s only debt is a bond that it has issued with a 5% rate, then its pretax cost of debt is 5%. If its effective tax rate is 30%, then the difference between 100% and 30% is 70%, and 70% of the 5% is 3.5%. The after-tax cost of debt is 3.5%.

The rationale behind this calculation is based on the tax savings that 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 by $5,000. As the company pays a 30% tax rate, it saves $1,500 in taxes by writing off its interest. As a result, the company effectively only pays $3,500 on its debt. This equates to a 3.5% interest rate on its debt.

Why Does Debt Have a Cost?

Lenders require that borrowers pay back the principal amount of a debt, as well as interest in addition to that amount. The interest rate, or yield, demanded by creditors is the cost of debt—it is demanded to account for the time value of money, inflation, and the risk that the loan will not be repaid. It also involves the opportunity costs associated with the money used for the loan not being put to use elsewhere.

What Makes the Cost of Debt Increase?

Several factors can increase the cost of debt, depending on the level of risk to the lender. These include a longer payback period, since the longer a loan is outstanding, the greater the effects of the time value of money and opportunity costs. The riskier the borrower is, the greater the cost of debt since there is a higher chance that the debt will default and the lender will not be repaid in full or in part. Backing a loan with collateral lowers the cost of debt, while unsecured debts will have higher costs.

How Do Cost of Debt and Cost of Equity Differ?

Debt and equity capital both provide businesses with the money they need to maintain their day-to-day operations. Equity capital tends to be more expensive for companies and does not have a favorable tax treatment. Too much debt financing, however, can lead to creditworthiness issues and increase the risk of default or bankruptcy. As a result, firms look to optimize their weighted average cost of capital (WACC) across debt and equity.

What Is the Agency Cost of Debt?

The agency cost of debt is the conflict that arises between shareholders and debtholders of a public company when debtholders place limits on the use of the firm’s capital if they believe that management will take actions that favor equity shareholders instead of debtholders. As a result, debtholders will place covenants on the use of capital, such as adherence to certain financial metrics, which, if broken, allows the debtholders to call back their capital.