The capital cost of debt represents the cost of financing a company through Debt. Recourse to external financing (non-equity financing), independently of being long-term or short-term, involves the payment of charges, most obviously interest; that is how entities provide finance reimburse themselves for each financing.
When financing through equity, there is no certainty about the return that equity holders may receive from holding the company and, in most cases, the benefit of holding the equity is only implicit because if no dividends are distributed (in most small and medium sized companies). Unlike equity, the cost of debt is based on financial instruments and, in most situations, there is a agreement of what that is cost of financing under each instrument (event if the cost is based on variable indexes, it can be estimated). It stems from the credit risk that financial institutions carry on business, as well as by investors in case of bonds. In any case the cost of debt is linked to a business-specific risk analysis.
Conceptually, the market interest rate that can be used as a reference for the cost of financing of a company, instead of the interest rate (or average interest rates of several financing contracts).
This example is merely an illustration, and in the real world it can easily be found cases where the market value of the cost of financing is below or above the cost that a company is currently taking. Adding more complexity to this observation, you should consider that:
- It is possible to renegotiate the company’s financing contracts, but it may come with an added cost, as financial institutions charge commissions on renegotiations.
- There are other implicit costs besides interest paid on the financing (commissions and other charges);
- Companies usually hold more than one financing instrument or contract. It is likely that different financing contracts have different interest rates, commissions and maturities.
Putting in practice
The cost of debt should reflect the different maturities and financings costs. However, that may not come without becoming quite complex and time consuming. While trying to simplify the calculation of the cost of financing, you can use a few options:
- The average interest rate of the loans (or similar credit contracts) held by the company.
- Use an average interest costs, by dividing the interest costs by the Debt (of a particular year). This approach is more adequate for businesses that have a stable financing structure, something that is not common for entrepreneurship projects.
- I: Interest costs.
- D: Debt.
- Use the interest rate of a most relevant loan held by the company.
- Undertake a market research of which interest rate and associated costs would the company get.
Tax shield – Cost of debt after the corporate tax
Interest costs are tax deductible and for that reason a levered company pays less taxes than an unlevered company (provided both have the exactly the same operational and investment performance). The tax shield represents the amount of tax that the company does not pay because it holds debt.
- \(Tax\ shield\ =\ I\times(1-t)\)
- I: Interest costs.
- T: corporate tax rate.
The “effective” cost of debt is cut by the presence of the corporate tax rate:
- \(Cost\ of\ debt\ “after\ corporate\ tax”\ =\ rd\times(1-t)\)