A company can raise money in two ways: through equity financing or debt equity. When it comes to the former, investors like VCs and angel investors put up cash flow in exchange for a stake in the company. An SBA loan, merchant cash advance, invoice finance, or some other form of financing could all be considered debt equity for a business. Interest is added to the loan balance and repaid over a while. Debt equity may sound like a fancy way of saying “loan,” and its use might be misleading. Let’s analyze its meaning and how to estimate cost of debt.
What is the Cost of Debt?
In simple terms, a company’s cost of debt represents the effective interest rate it incurs on its various forms of debt. For a firm, the cost of debt can be either the pre-tax or the post-tax cost of debt. Because interest payments can be deducted from your taxable income, they significantly affect the total cost of debt.
Cost-of-debt analysis can help businesses better comprehend the interest rate they are paying for debt financing. Since riskier businesses often have higher loan costs, this indicator will also give investors an idea of the enterprise’s level of risk relative to others.
How to calculate the cost of debt: The cost of debt formula
If you are interested in finding a cost of debt calculator, pay attention that there are several different approaches to determining the true cost of debt, depending on whether you are interested in the after-tax or before-tax figure. To determine the interest expense before taxes, apply the following formula:
Cost of debt = Total Interest/Total Debt
Step 1: You need to tally your annual interest costs before anything else. This number can be found on the income statement if your company generates financial statements. If you are compiling this information quarterly, sum up the interest payments for the full year.
Step 2: Add up all your outstanding debts and see where you stand. If you look at the balance sheet for your business, you’ll likely discover these entries under the “Liabilities” heading.
Step 3: When you have all the components’ cost of debt in hand, you can calculate the cost of debt for your company by dividing the interest expense by the total amount of debt it has.
For example, assume a company has loans from two sources: a $175,000 small business loan with a 5% interest rate from the bank. Another is a $55,000 loan with a 3% interest rate from a businessman.
Total Interest due = [(175,000 *5%) + (55,000*3%)]
= $8,750 + $1650
Total Debt amount = $230,000
Therefore, cost of debt = $10,400/$230,000
=0.045, which expressed as a percentage would be 4.5%.
Therefore, the effective pre-tax interest rate incurs on its debts is 4.5%.
What is the after-tax cost of debt?
Most people focus on the after-tax cost of debt instead of the pre-tax cost because interest payments are tax-deductible. After accounting for taxes, this is merely the interest you’ll pay on your debt. Unlike dividends distributed to holders of common or preferred stock, interest expense reduces taxable income, so the after-tax cost of debt is lower than the pre-tax cost of debt.
So, how to find cost of debt after taxes? We multiply the debt cost by the difference between 1 and the company’s tax rate. The effective tax rate is determined by combining the company’s state and federal tax rates, as opposed to the marginal tax rate, which incorporates tax offsets such as foreign tax rate deductions.
After-tax Cost of Debt = Effective Tax Rate x (1- Tax rate)
Using the value of the effective tax rate derived from the preceding example and assuming that your company’s tax rate is 35%, the after-tax cost of debt is computed as follows:
After-tax Cost of Debt = 4.5% x (1 – 0.35)
Therefore, the after-tax cost of debt for the business is 2.93%. The fact that interest costs are tax-deductible accounts for the majority of the difference between the cost of debt before and after taxes.
How to Lower Your Cost of Debt
Therefore, why compute your cost of debt? Because it indicates whether a company is spending excessively on funding. When you compute the tax cost, it might also indicate if taking on particular types of debt is prudent.
There are various ways of lowering the cost of debt. They include:
- Consider debt consolidation if you have high-interest rates on one or more of your loans. Debt consolidation typically entails combining several smaller loans into a single, bigger debt. This enables you to make just one payment each month instead of several. Your ability to pay your bills is simplified by consolidation. You have to make one monthly payment because all your debts are bundled. The monthly installment for your consolidation loan should also be less than the total of your individual loans’ monthly installments. Consolidation might not be your best choice if this is not the situation. Regardless of the type of loan you choose, the interest rate on your consolidation loan should be less than the average of the interest rates on your loans. This will reduce your monthly payment and help you save money over time.
- Start by being diligent when selecting your finance. The greatest business loans are the ones with low-interest rates, but you might not be eligible for them if your personal or business credit scores aren’t high.
- By making on-time payments on your bills and increasing your debt utilization, work on raising your credit scores.
In conclusion, you must be aware of the true cost of your company’s debt if the capital structure of your business involves long-term debt. While getting a business loan or utilizing a credit card can keep the money coming in, there is a cost involved. You’re taking a risk by ignoring that number.
When companies ignore the cost of debt, they frequently find themselves buried in loan payments that they cannot afford. Before taking out a loan, be aware of the cost of borrowing money. You should also compare products and rates to ensure you get the greatest deal. Once you know where to look for the inputs and the justification for the line items, calculating the cost of debt using the pre-tax and after-tax cost of debt calculation is a straightforward process.