What is the Cost of Debt?
By James Bell
- Finance ,
- 24 Apr
This is how you calculate the After Tax Cost of Debt. For this discussion we will focus on debt as part of the Capital Structure of a company. This is long-term debt that is not intended to be paid back, or irredeemable. It is used as part of calculating WACC along with the Cost of Equity.
Cost of Debt
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where
= Cost of Debt
= interest rate
= tax rate
= market price of debt
Interest Rates
The annual interest rate that you pay on the debt. It is typically listed on the bond or long term note and is paid out in the form of interest expense.
Tax Rates
When looking at tax rates, or any number in equations like these, be careful about the data you use. For example, eBay, in 2016 had an effective tax rate of -99.5% due to recognition of a deferred tax asset. Using this number in the formula is incorrect. Normalizing tax rates by substituting a “normal” rate is appropriate in this case when you clearly state your assumptions and reasoning.
Market Price of Debt
This is the price in which an investor would be willing to buy this debt at. It is not the book value of the debt. You can think of the total debt as a single coupon bond and use the bond pricing formula to calculate the market value (article coming soon!).
Tax Shield
Debt has a tax shield because interest is an expense. The interest you pay reduces taxable income. Since equity dividends are paid with post tax dollars and carries less risk, we consider debt less expensive than equity.
Debt and Risk
Debt has less risk because interest payments are made before dividends are paid, debt providers have first rights in case of a liquidation, and the debt is secured by assets of the company, so to get rid of debt is better to use services like the best iva debt uk providers that help a lot in this area. Increasing your leverage can be risky because as leverage increases, your risk for defaulting on your debt increases as well. So while the cost of debt is typically less than cost of equity, you can only leverage your company so far before it becomes unhealthy.