Cost of Debt Financing

A business normally uses a combination of equity and debt to finance its operations. The cost of debt includes the cost of loans from family and friends, bank loans, 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 are usually an expense and therefore reduce the tax liability of the business. Consequently the cost of debt finance is normally cheaper than the costs of equity finance.

How to Calculate Debt Cost

To illustrate consider a business which borrows 15,000 from a lender at an interest rate of 4%. Assume additionally the business has an income tax rate of 20%.

The pretax cost of finance is the interest rate of 4%. Assuming no repayments, the calculation of the interest expense is 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 finance cost to the business is the interest expense less the tax reduction. The calculation is as follows.

After tax cost of debt = Interest - Tax saving
After tax cost of debt = 600 - 120 = 480

If we now express this after tax finance cost as a percentage of the original debt, we get the following:

After tax cost of debt % = After tax cost of debt / Debt
After tax cost of debt % = 480 / 15,000 = 3.2%

The after tax cost of debt in this example is 3.2% of the principal amount of debt.

After Tax Cost of Debt Formula Example

The technique above is applicable to any interest rate and tax rate. The after-tax cost of debt formula is 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%. With these values the use of the debt equation is as follows:

After tax cost of debt % = Interest rate x (1 - Tax rate)
After tax cost of debt % = 4% x (1 - 20%) = 3.2%

As the tax rate increases, the tax reduction increases, and the after tax cost decreases. If the tax rate for the business was 30%, then the calculation of the after tax cost is as follows:

After tax cost of debt % = Interest rate x (1 - Tax rate)
After tax cost of debt % = 4% x (1 - 30%) = 2.8%

The after tax debt cost falls 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, it can always defer making dividend payments to the providers of equity finance. In contrast 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 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 financing is one component of the WACC calculation.

Debt Finance Cost in the Financial Projections Template

When using the financial projections template, the pre tax finance 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.