How to Calculate the Cost of Debt Capital

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

Your clientele is growing and you want to expand your business, but growth may require adding staff and inventory, and that takes money. Choosing the best way to borrow capital for your business is a unique challenge; it's important to know what options are available to you when risking the future of your business and personal livelihood.

Debt is an instrumental part of business for most entrepreneurs, and shareholders should know how to calculate the total cost they will pay on the loans they choose to accept.

The Cost of Debt

Calculating the total cost of debt is a key variable for investors who are evaluating a company's financial health. The interest rate a company pays on its debt will determine the long-term cost of any business loan, bond, mortgage, or other debts a company uses to grow.

A business owner without any debts can look at the interest rates being paid by other firms within the same industry to get an idea of the prospective costs of a certain loan for their business.

Calculating the Cost of Debt

The cost of debt is not strictly the cost of a company's loans, although they are an important variable in the calculation. Since the interest on the debt is tax-deductible, a business must multiply the coupon rate (the yield paid by a fixed-income security) 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 a 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, or 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. 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

The cost of debt capital reflects the risk level. If your company is perceived as having a higher chance of defaulting on its debt, the lender will assign a higher interest rate to the loan, and thus the total cost of the debt will be higher.

Using Debt or Alternatives to Raise Capital

Debt financing tends to be the preferred vehicle for raising capital for many businesses, but other ways to raise money exist, such as equity financing. Specific forms of alternative financing (and the components of the capital structure of the firm) are preferred stock, retained earnings, and new common stock.

Conventional financial wisdom recommends that companies establish a balance between equity and debt financing. It's crucial to choose the options that are most suitable for your staff, shareholders, and existing clientele.