Choosing a way to borrow capital can be challenging for any business so it is important to know what options you have available when risking the future of your business and your livelihood.
Debt plays a big role for small business owners and shareholders should know how to calculate the total cost they need to pay on the loans they accept. To calculate your cost of debt, there are a couple different formulas you need to know.
What is Cost of Debt?
Cost of debt is the total amount of interest a company pays on loans, credit cards, bonds, and other forms of debt. Knowing the interest rate and total amount of debt owed at that rate will help evaluate the overall financial health of your company.
Your cost of debt can tell you how taking out a loan will affect your finances and help determine whether debt makes sense for your business. It also helps potential lenders evaluate your ability to repay debt.
There are two major components that are included in calculating cost of debt.
- Cost of debt interest rate – need to know the interest rate you pay on your debt by using APR or your effective annual interest rate.
- Tax rate – need to know your tax rate. It represents your total rate between federal, state, and local tax rates.
There are two types of tax rates and they are effective tax rate and marginal tax rate. Your effective tax rate is the amount of federal income tax you pay as a percent of your total income and your marginal tax rate is the rate applied to the last dollar of your income.
Calculating Cost of Debt
There are two common formulas you can use which are the after-tax cost of debt and the yield -to-maturity cost of debt formula.
The after-tax cost debt formula is:
COD = EIR x (1 – ETR)
EIR is your effective interest rate and your ETR is your effective tax rate. Since interest payments are deductible and can affect your tax situation, most people pay attention to after-tax cost of debt than pre-tax. Knowing the after-tax cost of the debt you are taking is crucial.
The yield-to-maturity cost of debt formula is used when your debt is a bond and you are calculating the annual rate an investor earns if it is purchased and held to maturity.
The yield-to-maturity cost of debt formula is:
P = [the sum of t = 1 to n of [PMT sub t / (1 + YTM)^t] ] + [ FV / (1 + YTM)^n ]
P = the current market price of the bond
n = number of periods remaining to maturity
FV = the future value of the bond (face value)
PMT sub t = the interest paid in period t
YTM = yield to maturity
How to Lower Your Cost of Debt
Before you take out any loan, you will want to analyze your cost of debt and lower it as much as you can. The following examples are some ways to lower your cost of debt.
- Get a lower interest rate: you can do this by increasing your credit score and reducing your credit utilization on credit cards, pay any existing debt, and fixing any errors on your credit report.
- Refinance your loan: you can refinance with the lender that gave you the loan or with a new lender that offers better rates.
- Maximize your business’s growth potential: by increasing the income potential of your business you can afford to take on more expensive debt.
- Shorten the repayment term: if you have the cash flow, you can take out a loan with a shorter repayment term. Even if your interest is high your cost of debt will be low because you will not be paying interest as long as you would if you had a long-term loan.
Why Your Cost of Debt Matters
You need to know your cost of debt because it provides information you need to make a smart decision about a loan or other financing opportunities. It helps you and investors evaluate the financial state of your business. Having this information can improve your chances of getting approved for financing and help you make the best strategic financing decisions.