How to Calculate the Cost of Debt Capital

Business owner hanging an open sign
••• ┬áHero Images/Hero Images/Getty Images

Your business is growing and you need to expand. It's a wonderful problem to have! This growth may require adding more staff and building up inventory. To achieve this growth, you need capital. Choosing what's right for your business can be challenging; so, it's important to know the options and their associated benefits and disadvantages.

Debt is one component of a firm's capital structure and is usually the least expensive form of financing. Therefore, it's important for business owners to know how to calculate the cost of debt, which is the rate a business pays on its debt.

What the Cost of Debt is Based On

The cost of debt is usually based on the cost of the company's bonds. Bonds are a company's long-term debt or basically, the company's long-term loans. The cost of newly issued bonds is the best rate to use when calculating the cost of debt.

If a company has no publicly-traded bonds, then the business owner can look at the cost of the debt for other firms within the same industry to get an idea of what the cost of debt would be for their business.

How to Calculate the Cost of Debt

The cost of debt is not simply the cost of the company's bonds. Since the interest on the debt is tax-deductible, you must multiply the coupon rate on the company's bonds by (1 - tax rate):

Post-tax Cost of Debt Capital = Coupon Rate on Bonds x (1 - tax rate)

or Post-tax Cost of Debt = Before-tax cost of debt x (1- tax rate)

For example, a business with a 40% combined federal and state tax rate borrows $50,000 at 5% (interest rate). The post-tax cost of debt capital is 3% (Cost of debt capital = .05 x (1-.40) = .03 or 3%). The $2,500 in interest paid to the lender reduces the company's taxable income, which results in a lower net cost of capital to the firm. The company's cost of $50,000 in debt capital is $1,500 per year ($50,000 x 3% = $1,500) .

Flotation costs, the costs of underwriting the debt, are not considered in the calculation since those costs are negligible. You generally include your tax rate because interest is tax-deductible. However, it's also possible (and sometimes useful) to calculate your pre-tax cost of debt capital:

Before-tax Cost of Debt Capital = Coupon Rate on Bonds

If your company is perceived as a risky bet, then it will have a higher cost of debt; the cost of debt capital reflects the risk level.

Using Debt or Alternatives to Raise Capital

Debt financing tends to be the preferred vehicle for raising capital for many businesses. However, there are other ways to raise capital, including equity financing. Specific forms of financing and components of the capital structure of the firm are preferred stock, retained earnings, and new common stock. It is often recommended that companies establish a balance between equity and debt financing.

If you are looking to expand your business, raising capital is essential. It's important to choose options that are suitable for your business, shareholders, and stakeholders.