How to Perform a Cost of Debt Calculation
Understand the effective borrowing rate a company pays. This guide covers calculating the after-tax cost of debt for valuation and financial analysis.
The cost of debt represents the effective interest rate a company pays on its borrowings. It is a component in corporate finance, influencing decisions on whether to fund projects with new loans or bonds. This metric is a part of the Weighted Average Cost of Capital (WACC), a calculation used to evaluate the total cost of all capital sources for a business. Understanding this cost allows a company to assess its liabilities and make informed investment choices.
Key Components for the Calculation
The Pre-Tax Cost of Debt (Interest Rate)
The pre-tax cost of debt is the interest rate a company incurs on its financial obligations before accounting for taxes. There are two primary methods to determine this rate. The first is the book value approach, which provides a calculation based on historical data in a company’s financial statements. To find this effective interest rate, you divide the total Interest Expense from the income statement by the company’s total debt listed on the balance sheet.
A more forward-looking method is the market value approach, applicable when a company has publicly traded bonds. This approach uses the Yield to Maturity (YTM), which is the total anticipated return on a bond if it is held until it matures. YTM is considered a more accurate reflection of the current cost of debt because it reflects the market’s present expectations and the rate the company would likely pay if it issued new debt today. This figure can often be found on financial data platforms.
The Corporate Tax Rate
The corporate tax rate is another component for the calculation because interest payments on debt are tax-deductible. This feature creates what is known as a “tax shield,” which reduces a company’s taxable income and, therefore, its overall cost of borrowing. The specific rate to use is the company’s effective tax rate, which is its combined federal and state tax rate. This can be found in the footnotes of a company’s financial statements or can be calculated by dividing the income tax expense by the earnings before tax.
The Cost of Debt Calculation Process
The formula to determine the after-tax cost of debt is a direct application of the components previously gathered: After-Tax Cost of Debt = Pre-Tax Cost of Debt (1 – Tax Rate). This calculation adjusts the lender’s required return by the tax savings the company receives from deducting interest payments.
To illustrate using the book value approach, consider a company with a total interest expense of $50,000 for the year and total debt of $1,000,000. The pre-tax cost of debt is calculated by dividing the interest expense by the total debt, resulting in an effective interest rate of 5% ($50,000 / $1,000,000). If this company has a corporate tax rate of 25%, the after-tax cost of debt would be 3.75%, which is calculated as 5% (1 – 0.25).
Alternatively, if a company has publicly traded bonds with a Yield to Maturity (YTM) of 6.4%, this figure would serve as the pre-tax cost of debt. Assuming the same 25% corporate tax rate, the after-tax cost of debt would be 4.8%, derived from the formula: 6.4% (1 – 0.25).
Estimating Cost of Debt for Private Companies
Calculating the cost of debt for private companies is challenging because they do not have publicly traded debt, meaning there is no observable Yield to Maturity (YTM). The most common method involves using a synthetic credit rating to approximate the company’s creditworthiness.
This process begins by analyzing the private company’s financial ratios, such as the interest coverage ratio, and comparing them to the benchmark ratios of publicly rated companies. Once a rating is established, a corresponding default spread can be identified. A default spread is the additional yield investors demand to compensate for the risk of default, and this data is available from financial data providers.
The final step is to apply the estimation formula: Estimated Pre-Tax Cost of Debt = Risk-Free Rate + Default Spread. The risk-free rate is typically the yield on a long-term government bond, such as a 10-year U.S. Treasury bond. After calculating this estimated pre-tax cost, it is used in the standard after-tax formula to find the final estimated cost of debt.