Loading the player...

What is the '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.

BREAKING DOWN 'Cost of Debt'

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.

How to Calculate the Cost of Debt

To calculate cost of debt, a company must figure out 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%.

How to Calculate the Cost of Debt After Taxes

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.

RELATED TERMS
  1. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
  2. Debt Avalanche

    A method that involves making the minimum payment on each debt, ...
  3. Debt Load

    Debt load refers to the total amount of debt that a company is ...
  4. Cost of Capital

    Cost of capital is the required return necessary to make a capital ...
  5. Debt Fund

    A debt fund is an investment pool, such as a mutual fund or exchange-traded ...
  6. Debt Restructuring

    Debt restructuring is a method used by companies with outstanding ...
Related Articles
  1. Personal Finance

    Why Debt Isn’t Always a Bad Thing

    When managed properly, debt can be used to achieve a higher overall rate of return.
  2. Investing

    Does 2016 Spell the End of a Global Debt Cycle?

    Examine the growth of global debt from 2010 to 2015. Emerging market debt has grown significantly, while advanced economy debt has grown marginally.
  3. Investing

    What's a Debt Security?

    A debt security is a financial instrument issued by a company (usually a publicly traded corporation) and sold to an investor.
  4. Personal Finance

    What Millennials Should Know About Good and Bad Debt

    Can you tell the difference between good and bad debt?
  5. Insights

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  6. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  7. Insights

    Debt Monetization: A Nearsighted Government Policy?

    We look at whether this financial practice benefits a government in the long term.
  8. Personal Finance

    Sizing Up Debt

    Ever wonder if the different types of debt are good or bad? Read on and we'll tell you.
  9. Personal Finance

    Debt Settlement: Cheapest Way to Get Out of Debt?

    Debt settlement is not for everyone, but for those seriously in debt it may prove an effective means of solving the problem.
RELATED FAQS
  1. Do companies measure their cost of debt with before- or after-tax returns?

    Understand the before and after-tax calculations of cost of debt capital and how each is useful in deciding between funding ... Read Answer >>
  2. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >>
  3. How do interest rates influence a corporation's capital structure?

    Learn about how changing interest rates can affect a corporation's capital structure because of their impact on the cost ... Read Answer >>
  4. How is debt 'a relatively cheaper form of finance than equity'?

    When financing a company, the cost of obtaining capital comes through debt or equity. Find out which method generally provides ... Read Answer >>
Hot Definitions
  1. Capital Asset Pricing Model - CAPM

    Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and that is ...
  2. Return On Equity - ROE

    The profitability returned in direct relation to shareholders' investments is called the return on equity.
  3. Working Capital

    Working capital, also known as net working capital is a measure of a company's liquidity and operational efficiency.
  4. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  5. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  6. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
Trading Center