Cost of Debt
Meaning and definition of Cost of Debt
Cost of debt generally refers to the effective paid by a company on its debts. The cost of debt can be calculated in either before or after tax returns. However, the interest expense being deductible, the after tax cost is considered very often. Moreover, the cost of debt is one part of capital structure of the company and also includes the cost of equity.
As explained by Investopedia, the cost of debt measure is useful for giving an idea about the overall interest rate being paid for he us of debt financing by the company since a company uses a variety of bonds, loans, and other debt forms. Besides, the cost of debt is also helpful in providing the investors with an idea about the company’s riskiness as compared to that of the others. This is for the reason that companies with a higher risk involve a higher cost of debt.
How to Calculate the Cost of Debt
1. Collect information. For personal debt, long term notes are required along with equity lines of credit, mortgage and credit cards is required. For corporate debt, bond certificates of the company are required.
2. Compute the weighted average cost of debt on corporate debt or personal debt. Form a spreadsheet with Column A as “Type of Debt”, Column B as “Cost of Debt”, and Column C as the “Amount” associated with each type of debt. Also, if there are numerous interest rates consigned to one debt, they should be separated.
3. Create another spreadsheet to estimate the cost of debt for corporate debt by the use of long term debt.
4. Include a column D to both the spreadsheets as “Weight.” To compute the weight, take the total of Column C or the amount of debts. In column D, to obtain”Weight”, divide column C by the total of Column C thus obtaining the average of each dollar amount. The weights should figure to 1.00.
5. Multiply the interest rate (column B) by the weighting (column D). This would be called Column E (Weighted rate). Add this column to obtain the WAC of debt.
6. Calculate the after tax rate. Thereafter, take the rate in Step 5 and multiply it with (1-marginal tax) thus reaching the after tax cost of debt.