Calculating cost of debt (along with cost of equity) is an important part of calculating a company’s weighted average cost of capital (WACC), which measures how well a company has to perform to satisfy all its stakeholders (i.e. lenders and investors).
But you don’t have to be a hedge fund manager or bank to calculate your company’s cost of debt. Businesses calculate their cost of debt to gain insight into how much of a burden their debts are putting on their business and whether or not it’s safe to take on any more.
How to calculate cost of debt
To calculate your business’ total cost of debt—also sometimes called your business’ effective interest rate—you need to do three things:
- First, calculate the total interest expense for the year. If your business produces financial statements, you can usually find this figure on your income statement. (If you compile these quarterly, add up total interest payments for all four quarters.)
- Total up all of your debts. You can usually find these under the liabilities section of your company’s balance sheet.
- Divide the first figure (total interest) by the second (total debt) to get your cost of debt.
This isn’t an exact calculation, because the amount of debt you carry over the course of the year can vary. (If you want to be more precise, calculate the average amount of debt you carried for the year across all four quarters.)
Calculating cost of debt: an example
Let’s say your business has two main sources of debt: a $200,000 small business loan from a big bank with a 6% interest rate, and a $100,000 loan from billionaire investor Marc Cuban with an interest rate of 4% (he liked your pitch on Shark Tank).
The total annual interest for those two loans will be $12,000 (6% x $200,000) plus $4,000 (4% x $100,000), or $16,000 total. The total amount of debt is $300,000. So the cost of debt is:
$16,000 / $300,000 = 5.3%
The effective pre-tax interest rate your business is paying to service all its debts is 5.3%.
What is the after-tax cost of debt?
Because interest payments are deductible and can affect your tax situation, most people pay more attention to the after-tax cost of debt than the pre-tax one. This is just your cost of debt after factoring in taxes.
To calculate your after-tax cost of debt, you multiply the effective tax rate you calculated in the previous section by (1 - t), where t is your company’s effective tax rate.
Calculating after-tax cost of debt: an example
Let’s take the example from the previous section. If the effective tax rate on all of your debts is 5.3% and your tax rate is 30%, then the after-tax cost of debt will be:
5.3% x (1 - 0.30)
5.3% x (0.70)
= 3.71%
Your company’s after-tax cost of debt is 3.71%.
Wait a second. How can your after-tax cost of debt be lower than the pre-tax cost of debt?
Interest payments are tax deductible, which means that every extra dollar you pay in interest actually lowers your taxable income by a dollar.
For example, let’s say your friend offers you a $1,000 loan at 10% interest, and your company’s tax rate is 40%.
The total interest you’d pay your friend for that loan would be $100, all of which you can deduct on your taxes, which means your total taxable income goes down by $100. Because your tax rate is 40%, that means you end up paying $40 less in taxes.
Even though you’re paying your friend $100 in interest, because of the $40 in savings, really you’re only paying an additional $60. The after-tax cost of debt is lower than the pre-tax cost of debt.
Why this matters for your small business
According to the U.S. Federal Reserve, 43% of small businesses will seek external funding for their business at some point—most often some kind of debt. Knowing the after-tax cost of the debt you’re taking on is crucial when trying to stay profitable.
For example, let’s say you know that a piece of new equipment would increase your revenues by 5%. You don’t have enough cash on hand to pay for it outright, so you shop around for a loan. The cheapest one you can find has an after-tax cost of 7%. Should you take it?
Unless you think there’s some way the equipment could raise revenues by more than 7%, you shouldn’t take out the loan, because the extra revenues you’ll earn will be outpaced by the extra interest payments you’re making.
Like any other cost, if the cost of debt is greater than the extra revenues it brings in, it’s a bad investment.
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