How to Calculate the Cost of Debt
Calculating the cost of debt is pretty simple. Debt includes any long- or short-term debt that is used to finance the operations of a business.
The biggest influence on the cost of debt is simply the interest rate on debt incurred, measured by using the current value of future cash flows to repay the loans. Well, you’re looking at the same thing from the perspective of corporate costs of debt rather than investor potential for debt.
Still, if the time value of money was the only influence, you’d simply use the yield to maturity on all the corporation’s debt to determine the cost of debt.
You need to consider a number of issues, though:
Default risk isn’t a direct cost, but a company must anticipate that as the amount and proportion of debt it takes on increases, so, too, will the rate of return it must promise to attract investors increase.
A corporation with high amounts of debt or a high debt-to-equity ratio is at greater default risk, so to attract more investors looking for debt, it must offer higher rates. As a result, debt will become increasingly more expensive as the company relies on it more heavily.
Debt expenses are very frequently tax-deductible, decreasing the relative cost of debt. To calculate the tax rate applicable for debt capital, you simply multiple the pre-tax rate by (1-marginal tax rate), to get the after-tax rate, which is obviously lower by an amount equal to the proportion deducted for tax purposes.