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(With Formula And An Example) Updated 31 July 2023 For lenders and company stakeholders, it might be helpful to calculate the cost of debt. A company measures the debt cost to understand the overall rate it repays to lenders for the debts owned. Knowing the debt cost helps anyone with business finances manage their cash flows and understand the expenses. In this article, we define what debt cost is, know how it works, outline different ways to reduce it and explore the formula for calculating it, along with an example. Related: How To Calculate The Debt-To-Income Ratio (With Examples) Related jobs on Indeed Part-time jobs Full-time jobs Remote jobs Urgently needed jobs View more jobs on Indeed What Is The Cost Of Debt? The cost of debt is the rate of return a company pays on its debts, including loans and bonds. It applies to all the outstanding amounts. This cost accounts for the inflation, time value of money and opportunity cost if a bond or loan takes a longer payback period. Typically, the riskier the borrower company, the higher is the debt cost since the company has a high probability of defaulting and not making the full payment to the lender or creditor. When a company backs a loan with collateral, it lowers the debt cost, while unsecured loans and debts have a higher debt cost. The debt cost describes the amount of debt after taxes get considered. It is an excellent indicator of a company's financial health. As all interest expenses are tax deductible, the after-tax debt cost is lower than before-tax debt cost. The measure gives investor, lenders and creditors an idea of the company's risk level compared to others, as a riskier company have a higher debt cost. Related: How To Calculate Amortisation (With Definition And Example) How Does The Cost Of Debt Work? Debt cost is an integral part of the capital structure, with the other being the cost of equity. It is essential for a company to know its debt cost and cost of equity to finance regular operations and ensure future expansion. Typically, the debt cost of any business is lower than the equity cost. The debt cost typically relates to how a company funds its operation. It is for this reason debt cost applies to loans and bonds. Before a company borrows more money, they consider its debt cost and the income growth the debt might facilitate. Apart from the company's stakeholders and employees concerned with the company's growth, lenders assess the debt cost to decide whether the company is a risky investment. For instance, when a shoe store has a lower debt cost, it might consider taking an additional loan for opening a new store because it expects the new branch to make thrice the amount in its first two years of inception. If the same shoe store has a higher debt cost, it might delay its business growth until it pays back its debt and improves the cash flow. Related: What Is Growth Equity? (With Definition, Pros, Cons And FAQs) Formula For Formulating Debt Cost Knowing the annual interest rate for all debts is essential to calculate the debt cost. A company uses the weighted average cost of capital (WACC) rather than the simple interest rate for the calculation. This is because a larger loan costs a business more money over its lifetime than a smaller loan, even if it has a lower interest rate. The formula for calculating debt cost is: Debt cost = Interest expense (1 – tax rate) Interest expense or effective interest rate = (Annual interest rate / Total debt obligations) x 100 The tax rate is the rate of tax levied by the government. This formula considers external factors that can influence the situation, such as fluctuations inside the economy. It might consider the company's debt relief and its current credit rating. This helps in providing a more accurate and real-time debt cost. Ways To Reduce The Debt Cost Here are a few ways to reduce the debt cost: Improve the credit score The credit score of a company determines the interest rate. A company can reduce the interest rate they pay on future loans by improving its credit score. Repaying existing debts on time increases the score. Before borrowing a loan, it is essential for a company to regularly check for negative aspects affecting the company's credit score. Related: Debit Vs Credit In Accounting: The Key Differences Refinance the existing loan Typically, refinancing an existing loan means taking new loans to repay the existing ones. It is an excellent way to reduce debt costs. This might be helpful if the company gets a new loan with a favourable interest rate. Before refinancing the loan, a company considers credit checks and fees associated with legal documents and refinancing. A company might refinance the existing loan with creditors or lenders or from another lender. Offer collaterals Collaterals work as protection that minimises the lender's risk. If a company offers collateral to a lender, it is likely to decrease the debt cost. It helps in giving lenders added incentives to give them the loan they require. Typically, collateral is an asset a company offers the lenders and keeps until the company repays the loan. When the company defaults on its payment, the lender can keep the asset as its own. Negotiate lower interest It is not necessary to accept the default interest rate offered by the lender. Even though some lenders might remain firm, others might be negotiable. While the lender might remain firm on the interest rate, the company might negotiate a lower time. The negotiation efforts might yield desired results if the company can prove to lenders that they would repay the loan on time. A company can use a guarantor to sign for their loan to reduce the debt cost. Repay debts faster When a company pays its debt faster, it helps in reducing the debt cost. Often, a lender might accept extra payments and close loans faster without penalising the repaying company. Some lenders might charge an exit fee to pay the loan before the repayment term. Before agreeing to a loan, focus on negotiating the repayment terms. Related: What Is Debt Financing? (With Advantages And Disadvantages) What Factors Contribute To An Increase In Debt Cost? Here are some factors that might contribute to increasing the debt cost for a company: Capital structure Capital structure can increase the debt cost. When the debt is more than equity, giving a company more debt relief becomes challenging, making the loan costlier and riskier. This also means that the debt cost increases as the default risk increases. It implies that the cost of an organisation to pay back the loan increases and the chances for a lender to get back their loan amount decreases. Related: What Is Capital Structure? (With Types And Ways To Use It) Payback period The debt cost increases when a company takes a longer payback period to repay the loan. As a longer payback period drastically affects a company's financial position, it shows the lender that the borrower might not pay back its loans on time. Lenders might not prefer lending money to such a company because it makes the loan riskier. Related: What Is Capital Budgeting? (Definition And Methods) Example For Calculating Debt Cost Here is an example of calculating the debt cost: A leading perfume brand has three business loans, a ₹5,00,000 loan with a 6% annual interest rate, ₹12,00,000 mortgage loan with a 7% interest rate and a ₹8,00,000 business loan with a 5% annual interest rate. The company pays a tax of 30%. To calculate the debt cost, use this calculation: First, add the three interest rates Total interest rate = 7% + 6% + 5% = 18% Total loan amount = ₹5,00,000 + ₹12,00,000 + ₹8,00,000 = ₹25,00,000 Next, multiply the balance of each mortgage by the interest rate to get the weight per loan factor ₹5,00,000 x 0.06 = ₹30,000 ₹12,00,000 x 0.07 = ₹84,000 ₹8,00,000 x 0.05 = ₹40,000 Add these three weights per loan factor to get the total weight per loan factor. Total weight per loan factor = ₹30,000 + ₹84,000 + ₹40,000 = ₹1,54,000 Weighted average interest rate = (1,54,000 / 25,00,000) x 100 = 6.161% Debt cost = Interest expense (1- tax rate) = 6.161 (1 – 0.30) = 4.3127% The debt cost of the perfume brand is 4.3127%. In the above calculation, the perfume brand had simple interest-only debts. Typically, some complex debts amortise every month. If a business has amortising loans, the principles of each loan decrease every month and analysts consider this in their calculation.