Formula: How to Calculate Cost of Debt

What Is Cost of Debt?

When a lender or debt holder extends credit to a business, it’s making an investment on a future return. In other words, the lender expects to receive compensation for the risk it’s taking at some point in the future. 

Cost of debt is the term that describes how companies repay the lenders and creditors from which they borrow money. Cost of debt is the effective interest rate a company pays to creditors—also known as debt holders or lenders. 

Others may want to know your company’s cost of debt figures, because it can help them assess the risk of doing business with your company. For example, if your business is trying to attract new investments or apply for certain types of financing, investors or lenders may want to know your company’s cost of debt to assess the financial stability of your business. 

As a business owner, you may want to calculate cost of debt as well. Knowing your cost of debt can help you make sure your current business debts aren’t putting your company under too much pressure and can help you to determine whether or not it’s wise to borrow additional money for your business.

How to Calculate Cost of Debt

Before you calculate the cost of debt for your company, you will need to gather some information. Here’s what you need to get started:

• A list of the outstanding debts your business owes. 
• The APRs your business owes on each of its debts. 

You may have to estimate some of the figures above, since the debt your business carries throughout the year may fluctuate. This may be especially true if you have business lines of credit or business credit cards with revolving balances. Your overall debt figures may also experience some variations depending on whether you have fixed or variable interest rates.  

Next, it’s important to understand that there are multiple ways to calculate cost of debt. Two of the most common approaches to the cost of debt formula are to calculate the after-tax cost of debt and the pre-tax cost of debt. Below is a closer look at the cost of debt formula for each option. 

Pre-Tax Cost of Debt

To figure the pre-tax cost of debt for your business, start by adding your total interest expenses for the year. Then, divide that figure by your total number of business debts. 

Here is an example. 

Imagine your business has three debts:

• Business Loan A: $50,000 at 4% APR
• Business Loan B: $50,000 at 7% APR
• Business Loan C: $100,000 at 5% APR

In this scenario, then, your total debts would equal $200,000.

Next, assuming the loans above all have fixed interest rates, you would calculate the total annual interest expense as follows. 

• $50,000 X 4% = $2,000
• $50,000 X 7% = $3,500
• $100,000 X 5% = $5,000

Add up the three interest amounts for the debts and your total annual interest expense would equal $10,500.

Finally, you input all of the figures above into the cost of debt formula. 

In the example above, the pre-tax cost of debt—also known as the effective interest rate—that your business is paying to service all of its debts throughout the year would equal 5.25%. 

After-Tax Cost of Debt

Now let’s consider the after-tax cost of debt. The after-tax cost of debt is how much your business pays for its debts after you factor in the cost of taxes. 

Many interest charges are tax deductible for businesses. (Note: You should talk to a reputable tax advisor for advice on any specific tax-related matters.) So the after-tax cost of debt calculation is the more common figure that business owners, lenders, and would-be investors will likely want to review. 

To calculate the after-tax cost of debt, you will need to use the following formula. 

As you can see, this formula picks up where the pre-tax cost of debt formula left off. In other words, you must use the first formula to calculate the effective interest rate before determining the after-tax cost of debt. 

Below is an example of an after-tax cost of debt calculation to help you visualize how the process works. 

Building on the example above, let’s still assume that your business has an effective interest rate of 5.25%. Since tax rates vary for different businesses, for the sake of this exercise, let’s also just assume that your business is paying a 9% corporate tax rate. 

Now, let’s take a look at how the numbers align in this hypothetical after-tax cost of debt calculation. 

So, in the example above the after-tax cost of debt is 4.77%.

Why Does Cost of Debt Matter?

Choosing the right financing solutions for your company can have a meaningful impact on its bottom line. Avoiding financing can stall business growth and cause you to miss out on valuable opportunities for growth and expansion. Yet, if you overextend your business financially and its cost of debt grows too high, that can create problems of its own. Therefore, it is important to take the time to do some careful research before you seek financing and find the right balance that works for you.