When companies make decisions on how to best finance their operations, they have a number of different options. They could potentially sell equity, giving out ownership shares to folks who would then have a say in the company’s operation. Others fund their operation through debt financing. Debt financing can come in many forms. Some companies take out bonds, while others take out standard loans to get the business on its feet. To make a proper decision on whether to go with a debt or equity approach, it’s critical to calculate the cost of a debt. Here’s how to do that in the corporate sense.
Understanding what the cost of a debt means
The cost of a debt is the effective rate that companies pay, either before taxes or after taxes. When most people discuss the cost of debt, they’re referring not just to a single form of debt, but to the combined debt of a company. If a company has many different forms and sources of debt, then coming up with a combined understanding of that debt can give potential investors a picture of just how risky the company happens to be. As one might expect, having a higher cost of debt makes the company a riskier proposition because it begins to eat into the company’s cash flow.
How to calculate the cost of debt
Cost of debt is generally calculated as a percentage of the debt. For instance, imagine a scenario where a company has $1 million in debt at a rate of four percent. The company might also have $2 million in debt at a rate of five percent. To top it all off, the company issued $10 million in bonds at six percent. To figure out the cost of debt, one would need to do some simple math, taking all of these debt sources into account.
The total annual interest on the first loan would be $40,000. For the second loan, the interest total would be $100,000. Finally, the total interest paid on the bonds would be $600,000 in this scenario. This means that the total cost of interest is $740,000. To calculate the cost of debt, one would divide the cost of interest by the overall amount of debt financing. Doing the math, the company’s cost of debt in this scenario would be 5.69%. This is a relatively low cost of debt compared to many other competing companies, which would lead most investors to see the company as a low risk.
Thinking about the tax implications
Another thing that companies consider in regard to cost of debt is just how the tax implications play out. Because interest on some debt is tax deductible, one would need to calculate the tax savings to get a true cost of debt figure. If a company actually benefits be receiving $300,000 in tax deductions, for instance, then it must figure out if it will be able to use those deductions. If it can use them, then this reduces the cost of debt.