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.
- Understanding the cost of debt is key to evaluating a company's financial health.
- In most cases, the interest a company pays on its debt is tax-deductible.
- The formula for calculating the cost of debt is Coupon Rate on Bonds x (1 - tax rate).
- Most companies seek to establish a balance of equity and debt financing in order to maintain creditworthiness and control over the company's finances.
Understanding 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.
Most companies use debt strategically in order to keep capital on hand that will finance growth and future opportunities. While simply having any debt at all is by no means a bad thing for a business, being over-leveraged or possessing debt with too high of interest rates can damage a business' financial health.
A business owner seeking financing 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)
Example of Calculating the Cost of Debt
For example, say 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.
Frequently Asked Questions (FAQs)
What is the formula for calculating the cost of debt?
The formula for calculating the cost of debt is Coupon Rate on Bonds x (1 - tax rate).
What's the difference between debt financing and equity financing?
In debt financing, one business borrows money and pays interest to the lender for doing so. In equity financing, the business sells a portion of the company. Debt financing is much more common than equity financing.