How to Calculate the Cost of Debt Capital

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It's a wonderful problem to have. Your business is growing and you need to expand, taking on more staff or building up inventory. But doing so means you need to raise capital, which can be a challenge. It's important to know your options to raise capital as effectively as possible.

Debt is one component of a business firm's capital structure and is usually the cheapest form of financing for the company. Therefore, it's important for business owners to know how to calculate the cost of debt capital, which is the cost of the funds a business raises by taking out a loan.

Companies usually try to use as much debt financing as possible, since debt is generally inexpensive compared to the other forms of financing.

What the Cost of Debt 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 and are basically the company's long-term loans. The cost of newly issued bonds is the best rate to use if possible 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 of other firms in the same industry in order to get an idea of what the cost of debt would be for her business.

How to Calculate the Cost of Debt Capital

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

After-Tax Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate)

As an example, a business that borrows $50,000 at 5 percent interest and pays a 40 percent combined federal and state tax rate will pay interest of $2,500 per year. The business then will deduct the interest from its taxes, which will save it $1,000, making its cost of $50,000 in debt capital total $1,500 per year, or 3 percent ($1,500 total cost of loan divided by $50,000 loan).

Flotation costs or the costs of underwriting the debt are not considered in the calculation since those costs are negligible when it comes to debt.

You generally perform this calculation including 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. This equation is even simpler:

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, since the cost of debt capital reflects the risk level. Borrowing a lot of money can raise your cost of debt capital since that raises 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 obviously are other ways to raise capital. Other possible forms of financing and components of the capital structure of the firm are preferred stock, retained earnings, and new common stock.

If you are looking to expand your business, raising capital is essential. Doing so wisely, and in the cheapest way possible, can help your business' chances of success.