What is Cost of Debt?
The cost of debt is the actual interest rate that a company pays on its debts, such as loans and bonds. The debt cost indicates a business's risk and profitability and can be computed before or after tax. The cost of debt is also used to estimate the current value of a company by taking into account the expected returns for debt and equity holders.
How Cost of Debt works
The cost of debt affects the company’s capital structure, which is the ratio of debt and equity that a company utilizes to support its operations and expansion. Incurring a substantial interest rate on debt can restrict a company's ability to secure funding from lenders or shareholders, increasing the risk of default or insolvency. Contrarily, opting for a lower interest rate can position the company favorably in comparison to competitors, leading to reduced borrowing expenses and increased profitability.
The cost of debt may vary depending on the current market conditions, the company's credit rating, and the debt's type and term. A higher cost of debt indicates a higher risk of default and lower profitability for the company.
Example of Cost of Debt
A company has issued a 10-year bond with a face value of ₹1,000 and a coupon rate of 8%. The bond is currently trading at ₹950 and has a YTM of 8.9%. The company’s tax rate is 30%. The cost of debt using the YTM method is 8.9% x (1 - 0.3) = 6.23%. The cost of debt using the after-tax formula is (8% + 0.9%) x (1 - 0.3) = 6.23%.
Let’s take another example where a company has a long-term loan of ₹50,000 at a 6% interest rate and a bond of ₹100,000 at a 7% interest rate. The company’s tax rate is 30%. The cost of debt using the YTM method is not applicable, as the YTM of the loan and the bond are not known. The cost of debt using the after-tax formula is [(6% x 50,000 + 7% x 100,000) / 150,000] x (1 - 0.3) = 4.55%.