On the other hand, a company with a low debt burden may be able to get away with paying a lower interest rate. The agency cost of debt refers to the idea that management teams are often incentivized to take actions that favor shareholders over bondholders in a company. Now, let’s take a look at how the numbers align in what is the cost of debt this hypothetical after-tax cost of debt calculation. To calculate the after-tax cost of debt, you will need to use the following formula. When you need to perform calculations or carry out financial analyses, it’s common for the data you need to be spread out over multiple spreadsheets, often in different formats.
- Hence, the cost of debt is NOT the nominal interest rate, but rather the yield on the company’s long-term debt instruments.
- They can work with outside investors to raise equity, or they can borrow money in the form of debt.
- You can figure out what the cost of debt is by multiplying the value of your loan by the annual interest rate.
- On the date the original lending terms were agreed upon, the pricing of the debt — i.e. the annual interest rate — was a contractual agreement negotiated in the past.
Debt and equity are two ways that businesses make money, but they are very different. While we now know that the cost of debt is how much a business pays to a lender to borrow money, the cost of equity works differently. The effective interest rate is your weighted average interest rate, as we calculated above. You can find the information to find a company’s cost of debt from their balance sheet. Under “Current Liabilities” a company will list how much interest they have paid over that time period and how much debt remains. It’s helpful to understand that the cost of debt is a moving number.
How to Calculate the Cost of Debt
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The D/E ratio shows how much financing is obtained through debt vs. equity. Creditors tend to look favorably on a relatively low D/E ratio, which benefits the company if it needs to access additional debt financing in the future. Essentially, the interest rate demanded by creditors is the cost of the debt. When the creditors give a loan, they estimate the risks and the borrower’s chances of repayment of the debt.
Advantages of Determining the Cost of Debt
You have to compare the loan’s cost to the income the loan can generate for your business. As you can see, it is now lower because the principal balance decreases before the lender calculates the interest payment each month. In order for the loan to make sense now, the loan should generate more than $6,232 in net income in one year. As a preface for our modeling exercise, we’ll be calculating the cost of debt in Excel using two distinct approaches, but with identical model assumptions.
- The higher a business’s credit score, the less risky they appear to lenders — and it’s easier for lenders to give lower interest rates to less risky borrowers.
- In both cases, it’s not necessarily the amount of debt they assume, but how confident investors are that the debt will be paid back while still allowing the company to have operating capital.
- On the other hand, a company with a low debt burden may be able to get away with paying a lower interest rate.
- WACC equals the weighted average of cost of equity and after-tax cost of debt based on their relative proportions in the target capital structure of the company.
- Additionally, the cost of debt can be used to calculate the Weighted Average Cost of Capital, which considers both equity and debt.
- You’ll be blind to the true cost of your financing, and you might take out another loan you can’t afford.