Author:
John Stephens
Date Of Creation:
28 January 2021
Update Date:
1 July 2024
Content
The cost of debt is the effective interest rate a company must pay on a loan from a financial institution and other lenders. This can be a debt in the form of bonds, loans, and other forms. Companies can calculate the pre- or after-tax cost of debt by themselves. But since companies often get a tax deduction when paying interest, people usually calculate the after-tax cost of debt. Debt costs are very helpful in finding the interest rate that best suits a company's financial requirements. In addition, the cost of debt can also be used to measure a company's risk exposure, because a firm with a high level of risk typically has a higher cost of debt.
Steps
Part 1 of 4: Understanding corporate debt
Basic research on corporate debt. Debt is money borrowed by a business from another party and must be repaid on an agreed date. The company that borrows money is called a debtor or a borrower. The lending institution is called the creditor or lender. Businesses often borrow money from commercial or term loans or by issuing bonds.
Find out the meaning of a commercial loan and term. The commercial bank or lending institution will provide a commercial loan. Businesses use commercial loans for a variety of purposes, such as buying production equipment, increasing the workforce, buying or upgrading assets, or financing mergers and acquisitions.- Creditors do not have any ownership in the company.
- Creditors have no voting rights in the company.
- The interest on the loan is tax deductible.
- Unpaid debt is a liability.
Learn the different types of corporate bonds. Businesses that need to borrow large amounts of money often issue bonds. Investors buy bonds with cash. The company then pays investors both principal and interest.- The investors buying the bonds do not have any ownership in the company.
- The interest payable to investors is the interest on the bond. This may be the difference with the market rate.
- Market rates can cause the value of a bond to fluctuate, but not affect the interest rate a company pays to investors.
Part 2 of 4: Calculating the after-tax cost of debt
Understand why the after-tax cost of debt is calculated. The interest a company pays on its loan is tax deductible. Therefore, it is more accurate to adjust for tax savings when calculating the cost of debt. The net cost of debt equals the interest payable minus the deductible interest amount. The after-tax cost of debt will provide investors with more information about the stability of the company. Companies with high after-tax cost of debt can be a risky investment.
Determine the corporate income tax rate. Enterprises that are eligible under the State regulations will have to pay corporate income tax. This rate will be based on taxable income.
- In the US, for example, between 2005 and 2015, corporate income tax rates are between 15% and 38% of their income.For the first 50,000 USD in income, a lower tax bracket applies, and the tax rate increases to 35% as income increases. Businesses with higher income will be subject to a higher tax bracket.
- Companies providing individual services typically pay a flat tax at 35%.
- Some companies may also be responsible for paying accrued income tax of up to 20% if the taxable income is more than $ 250,000.
Determine the interest rate on debt. The interest rate on a company's commercial loan depends on the size of the loan, the type of credit institution and the type of business being financed. This information can be found in the loan application from the lender. The coupon rate will be indicated on the face of the bond.
Calculate the adjusted interest rate. Multiply the interest rate by 1 minus the corporate tax rate.
- For example, suppose a company has to pay 35% of the income tax rate and issue bonds at 5% interest. The adjusted interest rate will be calculated as follows: 0.05 x (1 - 0.35) = 0.0325. In this example, the after tax rate is 3.25%. The after-tax cost of debt would be calculated using a 3.25% adjusted interest rate.
- In the financial industry, the cost of debt is often envisioned as this adjusted interest rate and not another amount.
Calculate the annual cost of debt. To calculate the annual cost of debt, multiply the after-tax interest of the debt by the principal amount of the debt.
- For example, suppose the principal value of the bond is $ 100,000 and the adjusted after-tax interest is 3%. The annual cost of debt can be calculated using the following equation: USD 100,000 x 0.03 = USD 3,000. In this example, the annual bond issue cost is $ 3,000.
Part 3 of 4: Calculate the average cost of debt
Know why the average cost of debt is calculated. For many companies, especially large ones, financial debt involves a variety of loans, which may include some loans for transportation and real estate. In any case, the cost of debt of each loan must be accrued to calculate the company's total cost of debt.
- The average cost of debt is the combination of the cost of debt for each loan the company is borrowing. For accuracy, we will use the result calculated after tax, due to the fact that most companies around the world use this calculation.
Calculate the weighted average cost of debt. To calculate these costs, you'll need to calculate the cost of debt for each type of debt the company borrows. Use the formula above to calculate the after-tax cost of debt to determine each category. Then you need to calculate the average of these expenses. That is, you would have to calculate the average of each cost of debt based on the ratio of each debt to total debt.
- For more information on how to calculate weighted average, see more articles on how to calculate weighted average online.
- For example, let's say your company owes $ 100,000 in total. In which $ 25,000 is the loan with the after-tax cost of debt of 3% and $ 75,000 is the value of the bond with the after-tax cost of debt of 6%.
- The average cost of debt will be calculated by multiplying the cost of debt by multiplying the ratio of this debt to total debt ($ 25,000 / $ 100,000, 0.25) and then adding the product of the debt. the cost of using debt from the bond to the ratio of the debt to the total debt ($ 75,000 / $ 100,000, is 0.75).
- Thus, the average cost of debt would be 0.25 * 3% + 0.75 * 6% = 0.75% + 4.5% = 5.25%.
Understand the importance of cost of debt. Once you get the company's average cost of debt, you can use this data to analyze the company's situation or use it here to calculate a variety of other data. Knowing the cost of debt, in particular, can be helpful when comparing companies.
- The higher cost of debt is usually associated with a company with a higher risk. Investors often rely on this data to evaluate a company.
Part 4 of 4: Calculating the pre-tax cost of debt
Find out why the pre-tax cost of debt is calculated. If the tax identification number changes, the pre-tax cost of use is a very important factor. If the tax code changes one year so that the company is not allowed to deduct interest from income tax, the firm must know how to calculate the pre-tax cost of debt.
Calculate the cost of debt. Multiply the interest rate by your principal. For example, for a $ 100,000 bond with a 5% pre-tax interest rate, the pre-tax cost of debt can be calculated using the equation $ 100,000 x 0.05 = $ 5,000.
- The second method uses the adjusted after-tax rates and corporate tax rates.
Calculate the cost of debt with the after-tax adjusted interest rate. If the company doesn't disclose pre-tax interest rates for your loans, but you need that information, you can still calculate the pre-tax cost of debt. For example, suppose a firm has a 40% income tax rate and issues a $ 100,000 bond with an after-tax cost of debt of $ 3,000.
- Convert the tax rate to decimal by using the equation 40/100 = 0.40. Subtract the tax rate from 1 from the equation 1-0.40 = 0.60.
- Calculate the pre-tax cost of debt by dividing the after-tax cost of debt by the result found above. Get the equation 3,000 USD / 0.60 = 5,000 USD. In this example, the pre-tax cost of debt is $ 5,000.
Calculate the pre-tax cost of debt over the life of the loan. Multiply the pre-tax cost of debt by the number of years in the loan cycle.
- For example, suppose the company issues a 2-year bond. The total pre-tax cost of debt will be calculated by multiplying the annual cost of debt by 2. Get the equation $ 5,000 x 2 = $ 10,000. In this example, the total pre-tax cost of debt is $ 10,000.
