A business normally uses a combination of equity and debt to finance its operations. Debt includes loans from family and friends, bank loans and overdrafts, government loans, mortgages, and leasing.
The cost of debt financing is the interest and fees payable to the lender based on the principal amount borrowed and the term of the loan. These finance costs can usually be treated as an expense, and therefore reduce the tax liability of the business, this results in the cost of debt finance normally being cheaper than the costs of equity finance.
How to Calculate Debt Cost
Consider a business which borrows 15,000 from a lender at an interest rate of 4%, and the income tax rate for the business is 20%.
The pretax cost of debt is the interest rate of 4%, and assuming no repayments, the business would pay interest on the debt calculated as follows:
Interest expense = Interest rate x Debt Interest expense = 4% x 15,000 Interest expense = 600
However, this interest expense is tax allowable, so the business reduces its tax bill by an amount calculated as follows:
Tax reduction = Interest expense x Tax rate Tax reduction = 600 x 20% Tax reduction = 120
The after tax debt cost to the business is the interest expense less the tax reduction calculated as follows:
After tax debt cost = Interest - Tax saving After tax debt cost = 600 - 120 After tax debt cost = 480
If we now express this after tax debt cost (480) as a percentage of the original debt (15,000), we get the following:
After tax cost of debt = After tax cost of debt / Debt After tax cost of debt = 480 / 15,000 After tax cost of debt = 3.2%
The after tax cost of debt in this example is calculated as 3.2% of the principal amount of debt.
Cost of Debt Formula Example
The technique used above can be applied to any interest rate and tax rate by using the after tax formula for the cost of debt, which can be stated as follows:
The after tax cost of debt depends on the interest rate and on the tax rate.
In the above example, the interest rate was 4%, and the tax rate was 20%, using these values the cost of debt equation can be used as follows:
After tax cost of debt = Interest rate x (1 - Tax rate) After tax cost of debt = 4% x (1 - 20%) After tax cost of debt = 3.2%
As the tax rate increases, the tax reduction increases, and the after tax debt cost decreases. If the tax rate for the business was 30%, then the after tax debt cost would be calculated as:
After tax cost of debt = Interest rate x (1 - Tax rate) After tax cost of debt = 4% x (1 - 30%) After tax cost of debt = 2.8%
The after tax debt cost has been reduced from 3.2% to 2.8%.
Even in the initial startup phase when the business might not be generating taxable profits, the fact that losses can normally be carried forward and offset against future profits, means that the tax allowable nature of the interest expense usually makes debt finance the cheapest form of finance.
Of course there is always a downside, in the event that the business experiences a downturn in trade, in can always defer making dividend payments to the providers of equity finance, however, whether the business is making a profit or a loss, lenders will always want their loan repayments made, increasing the risk of the business running out of cash.
Cost of Debt Finance and WACC
Debt financing is only one method of funding available to a business, the other being equity finance. Most businesses use both equity and debt, and the proportion of each used results in a weighted average cost of capital (WACC) for the business. The cost of debt financing is one component of the WACC calculation.
Debt Cost in the Financial Projections Template
When using the financial projections template, the pre tax debt cost is simply the interest rate entered as one of the main assumptions on the income statement, this is more fully discussed in our how to find the interest rate tutorial. Likewise, the tax rate is also entered as an assumption on the income statement, and is more fully discussed in our how to find the tax rate tutorial.