Debt is a type of finance that companies from third-parties, such as financial institutions. It is a great source of finance to fund large acquisitions that companies may not be able to afford in other circumstances. In a debt arrangement, there are only two parties involved, the borrower and the lender. In the case of debt for companies, a company becomes the borrower. Similarly, a financial institution, such as a bank, becomes the lender. However, apart from banks, other third-parties can also provide debt to a company. These third-parties buy debt instruments of the company and provide finance to it in exchange.
The most common type of debt for companies comes in the form of bonds. Companies issue bonds to investors, who in exchange provide the company with a loan. Usually, the bond has a face value, which is the amount investors have to provide. In exchange for the loan they provide to the company, investors can receive interest based on a predetermined interest rate. Apart from bonds, there are also other types of debt that companies may obtain. All of these debts will have one thing in common, which is interest payments. This interest is the cost of that particular debt.
Companies may gather up different types that come with distinct interest rates. Therefore, they need to find the cost of debt.
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What is Cost of Debt?
Cost of debt of a company represents the effective interest rate it pays on its debt finance. As mentioned above, a company may use different sources of debt at the same time. Each type of debt will have its own cost. However, a company cannot use only a single type of debt when funding its operations. Therefore, it must find the effective cost of all those sources, known as the cost of debt. Cost of debt may also sometimes consider the tax implications of debts in addition to just its interest rates. It is because interest paid on tax can result in tax deductions for the company.
What is it used for?
The cost of debt of a company is a crucial part of its capital structure alongside the cost of equity. The capital structure of a company represents the combination of debt and equity it uses to fund its operations. Since every company will use debt alongside equity, it will also have a cost of debt. Once a company calculates its cost of debt, and cost of equity, it can calculate its total cost of capital, which is very important in the decision-making and capital budgeting process of the business.
The cost of debt is also used by companies to understand the overall costs they incur for the different types of debt they use. It can help them when deciding regarding whether they should obtain more debt or when making decisions regarding the interest rates of those debts. For a company, a higher cost debt means it is paying a high amount to use the finance.
Apart from companies, investors can also use the cost of debt to determine the risks levels associated with investing in a company. They can also use the cost of debts of companies as a comparison tool to evaluate investment options. Usually, a higher cost of debt means the risks involved in investing in the company are also higher.
How to Calculate the Cost of Debt?
A company can use the following cost of debt formula to calculate its cost of debt. This formula calculates the after-tax cost of debt, rather than the pretax cost of debt.
Cost of Debt = Effective interest rate (1 – Tax rate)
In the above formula, the effective interest rate can be calculated using the following formula.
Effective interest rate = (Annual interest rate / Total debt obligation) x 100
A firm could use its yields and prices of outstanding bonds to calculate the effective rate of interest. The effective interest rate represents the average interest rate that a company pays on all its debts, denoted in percentage.
Example and Calculation
A company, ABC Co., pays total annual interest of $4.5 million. Its total debt obligation is $50 million. The corporate tax rate prominent in the country that ABC Co. operates in is 20%. To calculate its cost of debt, ABC Co. must use the following formula.
Cost of Debt = Effective interest rate (1 – Tax rate)
However, ABC Co. must first calculate its effective interest rate to use in the above formula. It can calculate its effective interest rate using the equation below.
Effective interest rate = (Annual interest rate / Total debt obligation) x 100
Effective interest rate = ($4.5 million / $50 million) x 100
Hence, Effective interest rate = 9%
Now, ABC Co. can calculate its cost of debt using the cost of debt formula.
Cost of Debt = Effective interest rate (1 – Tax rate)
Then, we get:
Cost of Debt = 9% (1 – 20%)
Cost of Debt = 9% (0.08)
Hence, Cost of Debt = 7.2%
In the above example, the effective interest rate represents the pretax cost of debt of ABC Co. It is because the rate does not take into consideration the tax implications of debt. On the other hand, the cost of debt represents the after-tax cost of debt of the company. Usually, companies use the after-tax cost of debt for calculations instead of the pretax cost of debt.
Different Types of Cost of Debt
Depending on the type of finance in consideration, the cost of debt may have many types. These types are as below.
Perpetual debt
Perpetual debt is the type of finance without a maturity period. The calculation of the cost of debt for perpetual debt is similar to any other form of debt. However, there is an extra step involved. To calculate the cost of perpetual debt, a company must first determine the selling price of the debt instrument. If the debt instrument is selling at its face value, then the same formula as above can be used to calculate its cost. If the selling price is higher or lower than the face value, then the company will need to calculate its cost using the following formula.
Cost of Debt = 1 / Net Proceeds (1 – Tax rate)
Redeemable debt
For irredeemable debt, a company can use the standard formula to calculate the cost of debt. However, in the case of redeemable debt, which the holder can redeem at a future time, the calculation is different. For redeemable debt, the company can calculate the interest based on its face value and its cost based on its redemption value.
Callable debt
The cost of callable debt, which is a debt that a company refunds before the maturity debt, depends on its call period and call price. The call period is the time at which the company refunds the amount of debt. The amount it refunds is known as the call price.
How to Reduce Cost of Debt?
As mentioned above, a higher cost of debt can be problematic for companies. Similarly, investors may not prefer investing in companies with a high cost of debt. Therefore, companies must actively try to reduce their cost of debt. The first step in reducing the cost of debt starts before obtaining debt. When getting debt, companies should always try to find ways to get a lower interest rate. Getting a lower interest depends on credit scores, security, guarantees, negotiations, etc.
Companies can also refinance their loans. That is when a company obtains a lower-rate loan to finance a higher-rate loan. While this process is risky, it can result in high rewards in the company. Furthermore, it can also decrease the cost of debt for the company. Companies can also reduce the cost of debt by maximizing their return. While it will not reduce the cost of debt, it can help the company afford a higher amount of debt. Lastly, companies can also shorten their repayment terms to reduce the cost of debt.
Advantages
There are several advantages of debt as a source of finance. While it may take the cost of debt of a company higher, debt is also cheaper as compared to other sources of finance, such as equity. Similarly, debt allows a company to raise finance without losing control or dilution of ownership. Debt is also helpful when it comes to obtaining tax advantages. It is because the interest paid on debt is tax-deductible, which can be great for tax planning. Debt also allows companies to make predictions regarding the payments, thus, allowing it to budget accordingly.
Disadvantages
Debt can have some disadvantages as well. First of all, raising debt finance is more difficult because it may come with some requirements, such as high credit ratings, security, etc. Debt also requires companies to make fixed payments on time. In case of failure, the company can face legal problems. Debt can also affect the cash flow of a company. Especially when the company does not make profits, it can skip payments to equity holders. However, it cannot skip payments to its lenders. Similarly, some small size companies may not have assets to offer as collateral.
Conclusion
Cost of debt is the effective interest rate that a company pays to its debt instrument holders. While debt is cheaper than other sources of finance, obtaining more debt results in an increase in a firm’s cost of debt. The cost of debt is a crucial part of the capital budgeting and decision-making process of a company. In determining its cost of debt, a company can use the cost of debt formula. There are different types of cost of debts, depending on the type of finance. Companies can also use several techniques to reduce their cost of debt.
