Research in the SME sector shows that around 40-50% of companies seek debt financing at least once in their life cycle. It’s essential to understand the actual cost of Debt to make informed decisions within the business.
The Cost of Debt represents the effective interest rate the business pays on its debts.
Generally, the ratio refers to pre-tax cost. However, interest expenses are deductible for tax purposes, so we apply a tax shield on the Cost of Debt when we use it in financial modeling and analysis.
It is part of our business’s capital structure, with the other part being the cost of shareholder equity. The capital structure illustrates how the company finances its overall operations and potential growth initiatives.
The Cost of Debt is an important part of calculating the Weighted Average Cost of Capital (WACC).
Debt vs. Equity
We can use two types of capital to finance our business’s operations – Debt and Equity.
If we use equity, an investor provides working capital funds in exchange for share equity within the company. The investor expects to profit on their investment through dividends once the business becomes profitable or through an exit strategy once the firm increases its valuation.
On the other hand, Debt is when the company takes out repayable financing (basically a loan) that also requires the payment of interest on top of the principal amount but does not dilute the equity.
Understanding the Cost of Debt
The Cost of Debt is a useful metric outlining the average rate a company pays when using Debt to cover its financing needs. It’s the weighted average interest we pay on all Debt – loans, bonds, credit cards, overdrafts, and others.
Investors look at the measure as a risk indicator. A higher Cost of Debt usually reflects a riskier investment opportunity.
The Cost of Debt measure is usually lower than the cost of equity.
When creditors or lenders provide capital, they undertake part of the associated risk exposure. Therefore, we pay interest to provide them with a return on their investment. This is the actual Cost of Debt, and it reflects both the default risk of the company and the market interest rates.
The metric gives us the effective interest rate on the company’s Debt, showing the minimum return rate a debt holder will accept at the company’s risk level.
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Drawbacks of Debt and the Cost of Debt
A big drawback is the company’s obligation to pay Debt back with interest, following specific repayment terms and schedules. If a company can’t cover one of the payments, it may default on the liability and forfeit any collateral. And it’s important to remember, collaterals usually possess a higher value than the debt balance.
The business may also have to follow and meet specific covenants, like debt and liquidity metrics, to comply with the financing agreement.
The model’s biggest drawback is the assumption of a stable capital structure during the period we analyze, which is not always the case in real life.
Calculate the Cost of Debt (Kd) Ratio
In its pre-tax version, the Cost of Debt is equal to the Effective Interest Rate (EIR). We can calculate it using the following formula:
The company’s financial statements usually have the information within, so it’s easy to find the necessary data to calculate the above formula.
However, the after-tax Cost of Debt is the more interesting metric, so let’s take a look at how to calculate that. We need to apply the tax shield as mentioned above.
The Tax% is the weighted average tax rate for the company. We can calculate that by taking our total tax liability for the period and dividing it over the matching period’s total taxable income.
Yield to Maturity
If the Debt in the review is publicly traded, then the Cost of Debt is equal to its Yield to Maturity (YTM). The YTM represents the Internal Rate of Return (IRR) of the Debt. It’s the discount rate that brings the future cash flows back to the current market price.
However, the Yield to Maturity approach is useful only in scenarios where we know the Debt’s market price. If we don’t know it, there’s no way to calculate YTM.
We can look at the Yield to Maturity on similar debt instruments, applying a comparative approach in such cases.
Using the Cost of Debt
The after-tax version of the metric is the more popular of the two as an indicator for the business’ actual financial position.
The finance metric is widely prevalent among lenders, investment bankers, and investors. They use it to analyze the company’s capital structure, together with the cost of equity. It tells them if the company’s risk levels and returns provide for a good investment.
Within the business, we can evaluate how much of a burden debt is placing on the company.
We can calculate the income the loan amount will generate within the company and compare that to the cost of Debt. By knowing the actual cost of Debt and using this comparison, we can justify the loan transaction.
If we want to grow our business and expect an increase in net revenue at 8%, but banks offer funds with Debt’s actual cost at 9%, it makes no economic sense to get the loan, as the whole exercise will be generating a loss. However, this can still be something a company might consider if they believe the growth will pay off in the long-term.
When we are looking to finance capital investments, the Cost of Debt is an essential metric. It can help us a lot by showing us whether the Cost of Debt is below the expected income growth the CAPEX will generate. If that’s the case, then generally financing the capital investment via Debt is a sound economic decision.
Interest payments are tax-deductible and can have a potentially significant impact on the tax obligation of the company. Therefore the after-tax cost of Debt is usually more important for an analyst. The more interest we pay, the more this lowers our taxable income. This explains why the after-tax metric is lower than the pre-tax one.
Analysts also look at the Cost of Debt over time. We can then evaluate the trend the metric follows. If it increases, this is usually an indicator that the overall risk for the business is expanding.
Improving the Cost of Debt
There are a few things we can do to improve our Cost of Debt metric.
First, we need to be very careful when we consider debt financing. Before we enter into any loan agreement, we need to analyze its Cost of Debt and evaluate its impact on the business metric.
Another thing we can look into is consolidating smaller loans into a larger one. Generally, banks and lenders have associated risk levels, collaterals, and administrative costs with each loan. More often than not, financing institutions will be willing to drop the overall interest if we consolidated all loans into a single contract.
Last but not least, we must optimize and improve the way the company utilizes available Debt.
Let’s take a look at an example Cost of Debt calculation to illustrate the concept better.
Our company is considering a new loan facility, to support the growth of the business. Management has asked us to evaluate the actual cost of the Debt. The growth exercise we can help with the loan will yield around a 5% increase in income. It’s vital for the future development of the company’s operations, but we still want to know how viable is the suggested debt structure.
We want to fund €5.8 mil, and the bank has given us the following offer.
At first glance, the interest percentage is 0.5% below the company’s expected growth, so it seems an economically sound decision. However, here comes the importance of calculating the actual price for borrowing the money.
First, we can calculate the loan schedule using Excel’s formulas:
- PMT – for the total monthly repayment;
- PPMT – for the monthly principal repayment;
- IPMT – for the monthly interest expense.
I’ve seen some people skip that, but for me, if the period of repayment is above 12 months, we need to discount the future interest payments. To keep it simple, I will use the bank-offered interest rate to discount the three future cash outflows.
The next step is to calculate the pre-tax Cost of Debt. We can do this by taking the present value of the interest payable over the next three years and dividing it over the principal amount. This shows us how much it will cost to use the amount (looking at it from the current point in time).
We take the total interest over the loan course and divide it over the principal amount.
To calculate the after-tax Cost of Debt, which is our goal, we first need to calculate the average tax percentage.
The following information we can find in the financial statements of the company. Taking the tax liability from the Balance Sheet and the taxable income from the tax disclosures, we arrive at the following average tax %.
We can then apply the tax shield to our Cost of Debt and arrive at the after-tax metric.
As you can see, even though the nominal interest rate for the loan is 4.5%, the actual discounted cost of the financing will be at 5.64%, which is way above the expected income growth of 5%.
We need to discuss further whether the future growth opportunities following this project will justify taking out the loan at this Debt Cost.
The Cost of Debt tells us if we’re spending too much on financing. It also helps us evaluate if a new loan is economically right for the business.
It’s crucial to know the real price of borrowing money before we take out a loan. Otherwise, we can end up putting too big of a burden on the company and severely impact its cash flows and growth potential in the future.
The Cost of Debt is a prevalent metric because it gives much value to our decision-making process, and it’s relatively easy to gather the data to calculate it.
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