Cost of Debt: How to Calculate Cost of Debt

what is cost of debt

An investment’s pretax rate of return tells you how much its value has increased over some period of time, before accounting for any taxes that may need to be deducted. In corporate finance, the debt-service coverage ratio is a measurement of the cash flow available to pay current debt obligations. For example, if a company’s only debt is a bond that it has 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%. The cost of debt for a company is basically the amount of interest expense paid to debtholders and creditors.

How do you calculate cost of debt?

The basic formula for calculating the cost of debt is:

Total interest on debts for a year/Total debt

Here’s a basic example to illustrate the formula. In this example, a company has a $2 million loan with a 5% interest rate, a $400,000 loan with a 7% interest rate and they have issued an additional $2 million in bonds at a 6% rate. The interest rate on the loans calculates out to be $100,000 and 28,000 respectively. The bond interest calculates out to $120,000. The total debt is 4,400,000. Using the formula, this company’s cost of debt is as follows:

(100,000 + 28,000 + 120,000)/4,400,000 = 0.056 or 5.6%

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Define Cost of Capital and WACC

A higher cost of debt indicates that the company is more vulnerable. The weighted average cost of capital is the most common method for calculating cost of capital.

A debt calculator can also help you estimate the exact cost a company pays for the loan. If the Debt in the review is publicly traded, then the Cost of Debt is equal to its Yield to Maturity . It’s the discount rate that brings the future cash flows back to the current market price. We can calculate that by taking our total tax liability for the period and dividing it over the matching period’s total taxable income. As a business owner, you may want to calculate cost of debt as well.

Calculating Cost of Borrowing

Capital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc. The total interest expense incurred by a firm in cost of debt any particular year is its before-tax Kd. Divide the aggregate amount of interest by the average debt level to arrive at the pre-tax interest rate. Federal Reserve, 43% of small businesses will seek external funding for their business at some point—most often some kind of debt.

what is cost of debt