Cost of Debt Formula: What It Means and How To Calculate It

To calculate the after-tax income, simply subtract total taxes from the gross income. For example, let’s assume an individual makes an annual salary of $50,000 and is taxed at a rate of 12%. To arrive at the after-tax cost of debt, we multiply the pre-tax cost of debt by (1 — tax rate). The Cost of Debt is the minimum rate of return that debt holders require to take on the burden of providing debt financing to a certain borrower. You may have to estimate some of the figures above, since the debt your business carries throughout the year may fluctuate. This may be especially true if you have business lines of credit or business credit cards with revolving balances.

Now, let’s take a look at how the numbers align in this hypothetical after-tax cost of debt calculation. To calculate the after-tax cost of debt, you will need to use the following formula. Again, much of this information is sourced from external reporting. The after-tax cost of debt may be sourced from the debt disclosures contained in a company’s filings.

• After reading this article, you will understand what is the after-tax cost of debt and how to calculate the after-tax cost of debt.
• Beyond the general benefits of calculating a company’s after-tax cost of debt, the information is critical to understanding how much a company pays for all of its capital.
• Business owners can use this number to evaluate how a loan can increase profits.
• If taxes are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does exceed the cost of debt.

You now know what the term cost of debt means and how to calculate it before and after taxes. You also know how to use Microsoft Excel or Google Sheets to automate the calculations. The reason why the after-tax cost of debt is a metric of interest is the fact that interest expenses are tax deductible.

It is a single rate that combines the cost to raise equity and the cost to solicit debt financing. Businesses that don’t pay attention to cost of debt often find themselves mired in loan payments they can’t afford. Know what the true cost of borrowing money is before you take out a loan and compare products and rates to get the best deal possible. Work on building your credit scores by paying your bills on time and improving your debt utilization. If you have high interest payments on one or more loans, consider consolidating at a lower rate.

Calculating WACC in Excel

Multiple reasons exist for taking out a loan, ranging from issuing bonds to purchasing prime machinery in order to generate revenue and grow the business. It helps to know the actual cost of debt, and debt helps to justify the cost of debt in the business. There are numerous ways to secure business capital, and debt financing is at the top of that list. With debt financing, your business borrows money from a lender—often in the form of a short term loan or business line of credit—and agrees to repay those funds plus interest in the future. The idea of the after-tax cost of debt has been around for a long time. In fact, it was first introduced in the late 1960s by Robert McDonald, an expert on financing and corporate finance.

• In this article, we have discussed different aspects of the cost of debt, including calculation, uses, impact, and more.
• Because of this, the net cost of a company’s debt is the amount of interest it is paying, minus the amount it has saved in taxes as a result of its tax-deductible interest payments.
• But you don’t have to be a hedge fund manager or bank to calculate your company’s cost of debt.

If you didn’t have to pay taxes, then borrowing would be cheaper than raising equity. Let’s go back to that 6.5% we calculated as our weighted average interest rate for all loans. That’s the number we’ll plug bookkeeping & accounting task checklist into the effective interest rate slot. With debt equity, a company takes out financing, which could be small business loans, merchant cash advances, invoice financing, or any other type of financing.

What is a high cost of debt?

Then, divide total interest by total debt to get your cost of debt. When neither the YTM nor the debt-rating approach works, the analyst can estimate a rating for the company. This happens in situations where the company doesn’t have a bond or credit rating or where it has multiple ratings. We would look at the leverage ratios of the company, in particular, its interest coverage ratio. Before we dive into the concept of the after-tax cost of debt, we must first understand what is the cost of debt and the cost of debt formula.

Her expertise is in personal finance and investing, and real estate. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

What are the steps to calculate WACC?

WACC is essentially the average after-tax cost of attaining those sources of funding; it’s the average rate that the company can expect to pay to finance the assets that it has. We now turn to calculating the costs of capital, and we’ll start with the cost of debt. The weighted average cost of capital (WACC) is a financial metric that shows what the total cost of capital is for a firm. Rather than being dictated by a company’s management, WACC is determined by external market participants and signals the minimum return that a corporation would take in on an existing asset base. Companies that don’t demonstrate an inviting WACC number may lose their funding sources who are likely to deploy their capital elsewhere.

The loan lenders do not become an owner in the business, but they are first in line for the assets, if the company goes into liquidation. The after-tax cost of debt is an important financial metric for evaluating the financing cost of the business. It provides strong insights to assess financial leverage and interest rate risk for investing in the specific business as a lender. From a business perspective, tax-deductibility on payment of interest is considered an attractive feature as it positively impacts the net profit by reducing the taxable base. Suppose a company named AIM Marketing has taken a loan for business expansion of $500,000 at the rate of interest of 8%. The tax rate applicable was 30%; here, we have to calculate the after-tax cost of debt.

Cost of debt is the total amount of interest that a company pays over the full term of a loan or other form of debt. Since companies can deduct the interest paid on business debt, this is typically calculated as after-tax cost of debt. Business owners can use this number to evaluate how a loan can increase profits. Why do we use aftertax figure for cost of debt but not for cost of equity? The tax shield is a reduction in taxable income resulting from deductible expenses like interest payments on loans. Essentially, as interest becomes tax-deductible, the effective expense on interest decreases, lowering the cost of debt.

What Does a High WACC Mean?

But you don’t have to be a hedge fund manager or bank to calculate your company’s cost of debt. Businesses calculate their cost of debt to gain insight into how much of a burden their debts are putting on their business and whether or not it’s safe to take on any more. This formula first deducts the tax savings from the cost of interest. The result is an effective interest cost after deduction, the division of this amount with the total volume of debt results in an effective interest rate. The effective interest rate is defined as the blended average interest rate paid by a company on all its debt obligations, denoted in the form of a percentage. Conversely, as the organization’s profits increase, it will be subject to a higher tax rate, so its after-tax cost of debt will decline.

In our table, we have listed the two cash inflows and outflows from the perspective of the lender, since we’re calculating the YTM from their viewpoint. Each year, the lender will receive $30 in total interest expense twice. As a preface for our modeling exercise, we’ll be calculating the cost of debt in Excel using two distinct approaches, but with identical model assumptions. If the company attempted to raise debt in the credit markets right now, the pricing on the debt would most likely differ.

The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors. From the borrower’s (company’s) perspective, the cost of debt is how much it has to pay the lender to get the debt. This only considers the dividend yield component of the required return on equity. This is the current yield only, not the promised yield to maturity. In addition, it is based on the book value of the liability, and it ignores taxes. The after-tax cost of debt is a vital financial metric for businesses to grasp as it reflects the actual cost businesses must pay to service their debt, taking taxes into consideration.

You can figure out what the cost of debt is by multiplying the value of your loan by the annual interest rate. Determine your effective interest rate by adding together all that interest by the total amount of debt you owe. For example, if a company’s only debt is a bond that it 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%.

Don’t worry if this sounds technical, we explain in detail how you can obtain the cost of debt in the following section. Please use our bond YTM calculator and yield to maturity calculator. The cost of debt before taking taxes into account is called the before-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. Debt is one part of their capital structures, 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 refers to the effective interest rate paid on the company’s total debt. This value is usually an estimate, particularly if calculated using averages. The amount paid in interest expenses varies from item to item and is subject to fluctuations over time.