Cost of Debt

Reviewed by Sujaini | Updated on Aug 27, 2020

What is the Cost of Debt?

The debt cost is the effective rate of interest a firm pays on its debts. It's the cost of debt, including bonds and loans. The debt expense also refers to the pre-tax debt expense, which is the debt cost to the company before taking into account the taxes. The difference in debt costs before and after taxes, however, lies in the fact that interest charges are deductible.

Debt cost is one aspect of the capital structure of a company and also includes equity costs. A capital structure deals with how a firm finances its overall operations and growth through various sources of funds, including, among other types, debt such as bonds or loans.

The cost of debt measurement is useful in understanding the overall rate a company is paying for using these types of debt financing. The metric will also give investors an indication of the risk level of the enterprise relative to others, as riskier firms typically have higher debt costs.

Example of Cost of Debt

A company needs to determine the total amount of interest it pays on each of its debts for the year to calculate the cost of the mortgage. Then it divides the amount by the sum of its entire debt. The consequence of this is debt costs.

The debt calculation expense is the effective rate of interest, multiplied by (1-tax rate). The effective tax rate is the weighted average rate of interest on the debt of a firm.

For example, say a company has a loan of $1 million with an interest rate of 5% and an investment of $200,000 with a scale of 6 per cent. The effective interest rate is 5.2 per cent on its debt. The tax rate is 30 per cent for the company. Consequently, the debt level is 3.64 per cent, or 5.2 per cent * (1-30%).