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August 05, 2022

What is Cost of Debt

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Business owners who take loans from financial institutions are aware of such a concept, as the cost of debt. It’s a concept that a business owner must consider while using loaned money to improve business operations. Simply focusing on a loan’s monthly payments may not be beneficial for your business. Keep reading to learn more about the topic and how to lower the cost of debt.

Understanding Cost of Debt

The cost of debt (COD) is the company’s return it must provide to its debtholders and creditors. Lending to a company means that everyone involved in a business’s capital must get compensation for any risks of exposure.

Observable interest rates have a significant role in determining the cost of debt. When compared to calculating the cost of equity, it’s much easier to determine the cost of debt.

The cost of debt reflects the company’s risk, and at the same time, it determines the interest rates levels in the market. The cost of debt is also used to calculate a business’s WACC (Weighted Average Cost of Capital).

Here are some of the most important facts about COD:

  • It is a rate that a business must pay on acquired debt (a bond or a loan).
  • Debt is considered a part of the company’s capital structure.
  • The calculation of COD is simple, and an accountant has to find the average interest paid on all of a business’s debts.

Now let’s learn how the cost of debt works and the formula to calculate COD.

How does it Work?

Debt is one of the components of a company’s capital structure. The other component is equity. Capital structure focuses on a business’s ways of financing its operations and growth through various sources of money. As one may assume, some of such sources of money come through a loan or a bond.

The cost of debt is used to calculate the overall rate that a company has to pay to get these sources of finance. These calculations also provide investors with a better understanding of the business’s risk level in comparison to other businesses. Typically, the higher the risk, the higher is the cost of debt.

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Cost of Debt Formula

Typically, companies use either cost of debt pre-tax or post-tax formulas to determine COD. Let’s check the first formula:

(Total Interest Cost Incurred / Total Debt) X 100 = Cost Of Debt (Pre-Tax Formula)

Another formula that requires calculating COD post-tax looks as follows:

(Total Interest Cost Incurred * (1- Effective Tax Rate)) / Total Debt x 100 = Cost Of Debt (After-Tax Formula)

You may also consider free calculators. There is no difference in how to calculate — manually or by using online software.

What is Cost of Debt

Calculating Cost of Debt

To better understand how to calculate COD, check the following instructions:

  • Determine the total interest expense for one fiscal year. If a company is generating financial statements, then take a look at your income statement to find interest expenses. Total up all interest payments if generating quarterly income statements.
  • Add all the company’s debts. Take a look at the company’s balance sheet (excel or in accounting software) to find all debts in the liabilities section.
  • Divide total interest by total debt.

As you see, it’s rather easy to determine the cost of debt. It may vary every year if a company takes more debts or pays off existing ones. Now let’s take a look at some of the examples of calculating COD.

Cost of Debt Example

Tomas’s Bakery is a small business that acquired two loans:

  • a $350,000 mortgage with a 5% annual interest rate;
  • a $250,000 business loan with a 4% annual interest rate.

The owner of Tomas’s Bakery, Tomas, had to do the following calculations to figure out the business’s COD:

  • Adding 5% and 4% together gives Tomas a total interest rate of 9%.
  • Multiplying the balance of each company’s loan by its respective interest rate. The first loan, $350,000, is multiplied by 0.05; this gives Tomas $17,500. Then Tomas multiplies $250,000 by 0.04, which gives him $10,000.
  • Adding $17,500 and $10,000 to get a total of $27,500. This figure reflects a weight loan factor.
  • Dividing a loan weight factor by the total amount owed. Tomas divides $27,500 by $600,000, which gives him an average interest rate of 0.05%.
  • Determining the cost of the debt rate. Tomas’s Bakery pays a 20% federal tax plus a 5% state tax, in total 25%. It multiplies the weighted average interest rate by one minus the company tax. To put it simply, 0.05% x (1–25%), so COD is 0,04%.

Note that Tomas’s Bakery has only simple interest-only debts. In some cases, businesses take amortizing loans. When calculating COD in such cases, accountants should remember that amortizing loans decrease each month.

How to Reduce Cost of Debt?

It’s clear that the lower your cost of debt, the higher are your chances to attract more lenders and investors. Low COD signals that a business pays its debts. No wonder many businesses try to reduce their COD. Luckily, there are quite a few legal ways to lower the cost of debt. Keep reading to learn more.

Negotiate Lower Interest Rates

Some business owners don’t yet realize that they don’t have to agree to default interest rates. Some financial institutions will decline your more reasonable offers, but you may always find another lender.

Some lenders are open to negotiation, and it’s worth a shot to try getting better conditions. The key factor in lowering the interest rate is to provide proof of the company’s reliability when it comes to paying debts. The proof could be business or personal assets as collateral. It’s also possible to get a guarantor to sign for a loan.

If you fail to negotiate better conditions, there is still a possibility to lower the interest rate in the future. Consider paying more than the minimum regular payment and always on time. This may encourage the lender to agree to reduce the interest rate.

Credit Score Improvements

The credit score always affects the interest rate. Improving this factor can significantly reduce the interest rate a company pays on future loans.

Reducing dependence on credits and also returning any existing loans helps in increasing a company’s credit score. Check all company’s credit reports to ensure there are no typos or mistakes that may negatively affect the score.

Try Repaying Debts Faster

It’s a tricky option since some banks or banking institutions aren’t interested in businesses paying their loans faster. In some cases, businesses are forced to pay exit fees for paying and closing debts faster.

Before taking a loan, consider negotiating the terms. Ensure you won’t be penalized for paying faster.

Refinance Business Loans

What does refinancing mean? In this case, it means taking new loans to repay existing ones. It may be a good option to reduce the cost of debt, but only if a business manages to get a new loan with a more favorable interest rate.

It’s critical to factor in the cost of legal documents, fees for refinancing, and credit checks. It’s even possible to ask for refinancing a business loan from an existing lender. If it’s impossible, consider taking a loan, in cash or not, from another financial institution.

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Author: Charles Lutwidge

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