How to calculate the cost of debt for WACC?
The cost of debt for a company is basically the amount of interest expense paid to debtholders and creditors. While there is a lot that goes into determining the interest rate that banks and creditors charge, the basic idea is that the interest rate covers the return and risk exposure that comes with lending money to a company.
From a company’s perspective, the cost of debt would just be the interest rate that they pay on the debt. The interest rate is typically observable, but you could also calculate the interest rate by dividing annual interest expense into the company’s outstanding debt to get the effective interest rate. Additionally, there is a tax benefit for debt as interest expense is deductible for calculating taxable income. The cost of debt should always be presented after factoring in tax savings.
Cost of Debt (Effective interest rate) Example:
Below is an example scenario where we need to calculate the effective interest rate and apply the tax impact to calculate the cost of debt on the loan.
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