The cost of debt is the after-tax effective rate paid by a borrower. The cost of debt comprises a portion of the total cost of capital of a business, of which the other parts are the cost of preferred stock and the cost of equity. The cost of debt is the least expensive part of the cost of capital, since it is tax deductible. Given the lower cost of debt, there is a temptation to take on an excessive amount of debt in comparison to the other elements of the cost of capital; however, doing so increases the amount of loan principal to be repaid, as well as interest, which increases the bankruptcy risk of the firm.
Follow these steps to calculate the cost of debt:
- Calculate the aggregate amount of interest to be paid over a one-year period.
- Calculate the average amount of debt outstanding during the one-year period.
- Divide the aggregate amount of interest by the average debt level to arrive at the pre-tax interest rate.
- Subtract the organization’s tax rate from 1, and multiply the difference by the pre-tax cost of debt.