In the first month of 2023 alone, the tech sector laid off over 56,000 workers. After years of seemingly unstoppable growth in the tech world, the uptick in lay-offs gave many people a sense of whiplash. One of the major causes of this sudden shift in fortune for the tech industry was a shift in the cost of debt.
For many years, the tech industry took advantage of low-interest rates, using debt to fuel rapid growth. Because money was so cheap to borrow, companies could thrive for years without ever producing a profit.
However, when interest rates began rising in 2022, borrowed money no longer looked so appealing. Companies had to scramble to cut costs, deleverage, and shrink down to a size that is sustainable in today’s high-interest rate environment.
The recent trouble in the tech industry shows how much debt costs can impact companies, individuals, and the overall economy. In this article, we’ll discuss how to find the cost of debt and how to use that knowledge to guide your company to success.
Key Takeaways
- The cost of debt is the interest rate a borrower must pay on borrowed money, such as bonds or loans.
- Weighted average cost of capital (WACC) is a measure of both the cost of debt and the cost of equity.
- The primary way to lower your debt costs is to lower your interest rate.
- Business leaders should look at numerous financial metrics to determine their company’s financial health.
What Is Cost of Debt?
The cost of debt is the interest rate a borrower must pay on borrowed money, such as bonds or loans. A company’s total cost of debt is calculated by adding total interest expense and dividing it by total debt. The cost of debt is a critical measure because it directly impacts a company’s profitability and cash flow. A high debt cost also indicates a higher level of financial risk for a company.
The total cost of debt is influenced by the interest rate on each loan the business takes out. The rate is determined by the lender and is based on a variety of factors.
Here’s a list of things that can impact a company’s rate:
- Creditworthiness
- Term of the loan
- Loan amount
- Type of debt
- Current market rate
- Risks associated with the loan
- Lender’s costs
Why Does Cost of Debt Matter?
The three biggest reasons that calculating the cost of debt matters are:
- Helps businesses make informed decisions
- Highlights financial risk
- Allows investors to evaluate a company’s capital structure and financial health
Evaluating the cost of borrowed money allows a business to make informed decisions about financing its operations. When considering whether or not to take out a new loan, a business leader can calculate how it will impact the company’s overall cost of debt and whether it is worth the expense.
A company with a high cost of debt has greater financial risk, while a company with extremely low debt costs may not be pursuing important growth opportunities. Investors may look at a company’s debt costs and avoid getting involved if those costs are too high or too low.
Calculating the Cost of Debt
Pre-Tax Cost of Debt Formula
The simplest way to calculate cost of debt before tax is with the following formula:
Total Interest / Total Debt = Cost of Debt
Example
Company A has a $500,000 loan with a 3% interest rate, a $750,000 loan with a 6% interest rate, and a $300,000 loan with a 4% interest rate.
The company calculates its total interest like this:
(500,000 X 0.03) + (750,000 X 0.06) + (300,000 X 0.04) = 72,000 = Total Interest Paid
Company A then adds up the total debt it holds:
500,000 + 750,000 + 300,000 = 1,550,000 = Total Debt
Now, Company A divides total interest by total debt:
72,000 / 1,550,000 = 4.645%
4.645% is Company A’s pre-tax cost of debt.
After-Tax Cost of Debt Formula
Interest expense is tax-deductible. This tax write-off reduces the cost of debt because it eliminates some or all of the expense of borrowing money. Because of this, looking at the after-tax cost of debt gives companies a more accurate understanding of their expenses. To calculate the after-tax debt cost, use this formula:
Pre-Tax Cost of Debt X (1-tax rate) = After-Tax Cost of Debt
Example
Company A calculated its pre-tax cost of debt to be 4.645%. Its tax-rate is 21%.
So the company’s after-tax debt cost is calculated as:
0.04645 X (1 – 0.21) = 0.03669
Company A’s after-tax cost of debt is 3.67%.
Understanding Cost of Equity
Businesses finance their operations using both debt and equity. While the cost of debt is the rate of return that lenders expect from borrowers, the cost of equity is the rate of return that shareholders expect from companies they hold partial ownership in. The cost of equity is typically higher than the cost of borrowed money because equity financing does not have any tax advantages.
While the cost of equity is an expensive form of capital, companies with too much debt have a higher risk of defaulting on their debts. Because of this, investors like to see a healthy mix of financing through both debt and equity. WACC, or weighted average cost of capital, is one way to measure that mix.
Understanding WACC (Weighted Average Cost of Capital)
WACC measures the cost of both debt and equity. It is one of the most commonly used formulas in corporate finance because it evaluates the capital structure of a company and measures the cost of all types of capital. This formula reveals whether a company is using its capital efficiently. While the weighted average cost of capital is a complex formula, it is frequently used as the main metric of whether a company is successful. To calculate this metric, follow these steps:
- [Market Value of Equity / (Market Value of Equity + Market Value of Debt)] x Cost of Equity = A
- [Market Value of Debt / (Market Value of Equity + Market Value of Debt)] x After-Tax Cost of Debt = B
- A + B = WACC
Important
WACC is important to understand when looking at cost of debt because this metric is rarely looked at in isolation. This financial metric is nearly always evaluated in conjunction with the cost of equity and WACC.
Is There a Way to Lower Debt Costs?
The primary way to lower your cost of debt is to lower your interest rate. If you hold high-interest rate debt, look into your options for refinancing and consolidation. It’s possible the lender you worked with originally did not give you the best rate possible, or maybe your credit score has improved since you took out the loans. Talk to lenders about your options for refinancing or consolidating your debt to get a lower rate.
If you’re unable to find better rates initially, work on improving your business credit score. To improve your credit score, open a business credit card, and avoid spending over 30% of your credit limit.
Because interest rates have been rapidly rising throughout 2022 and may continue to rise in early 2023, it may be difficult to find low-interest rate options. If that’s the case, you may want to consider ways to get out of debt or reduce the debt at your company.
Don’t Look at Financial Metrics in Isolation
A good business leader is an informed business leader. While the cost of debt is a critical measure to be aware of, it’s important to look at it in conjunction with other metrics.
Here are a few other formulas to evaluate the financial health of your company:
- Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity: This ratio reveals the extent a company finances operations with debt versus financing with its own resources.
- Quick Ratio = Current Assets – Inventory / Current Liabilities: This ratio measures a company’s liquidity or its ability to meet its financial obligations if they were to become due at once.
- Net Profit Margin = (Gross Income – Total Expense) / Revenue x 100: The net profit margin reveals what percentage of revenue a company keeps after paying all of its expenses.
- Return-on-Equity = Net Profit / (Beginning Equity + Ending Equity) / 2: This formula is a measure of profitability that investors use to evaluate how well a business utilizes equity investments to produce value.
- Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities: Similar to the quick ratio, the operating cash flow ratio is a liquidity measure. However, this ratio measures a company’s ability to meet its obligations through its cash flow rather than its current assets and inventory.
Each of these formulas can help you understand your company’s financial position more thoroughly, allowing you to make better business decisions. To continue learning about the world of corporate finance, check out this article:
Economies of Scope: What Are They and How Do They Maximize Profit
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