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How is the cost of debt calculated?
The "cost of debt" can let one understand what they are paying for the benefit of having fast access to cash. The cost of debt is calculated by adding up all loans, balances on credit cards, and other financing tools the company has. The interest rate expense for each year is found and added. Next, the total interest is divided by the total debt to get the cost of debt.
Cost of Debt Formula
There are multiple ways to calculate the cost of debt, depending on pre-tax or post-tax rates. The pre-tax cost of debt is calculated with the above method and the following formula cost of debt formula −
$$\mathrm{Cost\:of\:Debt =\frac{Total \:Interest}{Total\:Debt}}$$
But often, if there are deductible interest expenses on the loans, one can save taxes. Here is where calculating the post-tax cost of debt comes in handy. To do so, one will need to know the effective tax rate.
Let’s take another definition before going to use the formula − weighted average cost of your debt. This refers to the net total interests one is paying for all the loans. To get the weighted average interest rate, multiply each loan with the interest rate you pay on it.
For example −
SBA loan − INR 100,000 × 5% =INR 5,000
Business credit card − INR 5,000 × 22.5% = INR 1,125
Merchant cash advance − INR 3,000 × 30% = INR 900
Then add those results together.
INR 5,000 + INR 1,125 + INR 90 = INR 7,025
Next, add up all your debts −
INR 100,000 + INR 5,000 + INR 3,000 = INR 108,000
To calculate the weighted average interest rate, divide your interest number by the total you owe.
$$\mathrm{\frac{INR \:7,025}{INR\:108,000}=0.065}$$
6.5% is the weighted average interest rate.
Now, let’s go back to that formula for the cost of debt that includes a tax cost at your corporate tax rate.
Effective Interest Rate × (1 – Tax Rate)
The effective interest rate is the weighted average interest rate, as calculated above. In the next section, we’ll look at examples using these formulas.
Cost of Debt – Examples
As mentioned, there are two ways to calculate the cost of the debt, depending on whether it is pre- or post-tax.
Simple Cost of Debt
To know just how much you’re paying in interest, use the following simple formula.
$$\mathrm{Cost\:of\:Debt =\frac{Total \:Interest}{Total\:Debt}}$$
If you’re paying a total of INR 3,500 in interest across all your loans this year, and your total debt is INR 50,000, your simple cost of debt will be 7%
$$\mathrm{Cost\:of\:Debt =\frac{3,500}{50,000}× 100 = 7 \%}$$
Complex Cost of Debt
If the cost of debt changes after taxes.
Effective Interest Rate × (1 – tax rate)
Let’s consider the 6.5% we calculated above as our weighted average interest rate for all loans. That’s the number we’ll use as the effective interest rate slot. If one has a 9% corporate tax rate. Here’s how the cost of debt formula would look.
0.065 × (1 − 0.09) = 0.591, which is 5.9 %
So, after tax savings, your cost of debt is 5.9%.
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