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How to Measure the Cost of Debt for a Business

The return that the debtors and creditor achieve from a company is termed as the cost of debt. Lending a substantial amount to a company exposes the capital providers to a considerable amount of business risk, which needs to be compensated. Instead of calculating the cost of equity, it’s easier to calculate the cost of debt since the cost of debt is quantified by the real interest rates. Alongside the market interest rate level, the company’s default risk may even get reflected by the cost of debt. Apart from this, this constitutes an important factor depicting the weighted average cost of capital for the company.

Determining the Cost of Debt

The cost of debt can actually be estimated in 2 common ways. The Yield to maturity of an organization’s debt has to be checked out. The debt of a company is easily observed in the market if it’s a public company. For instance, the straight bond pays interests on a regular basis and even pays off the principal amount once it gets matured. Whenever a company has a not-so-complicated capital structure, it takes this approach as it doesn’t have to deal with debt in multiple folds. The interest rates would even vary between the senior debt and the subordinated debt.

In order to gain estimation on the cost of debt, a company needs to consider its comparable debts and latest and implied credit rating if it doesn’t bear any market data. The capital structure of the organization has to match its competitors while comparing these factors. A rating can be achieved by the analyst if both the debt-rating and YTM approach fail. It usually occurs under circumstances when the company either has multiple credit ratings or doesn’t have any rating or bond.

The Actual Cost of Debt Is Arrived At By Applying This Formula:

After-Tax Cost of Debt = Cost of Debt x (1 – Tax Rate)

The interest coverage ratio and other leverage ratios of the organization will be considered while determining their cost of debt. The borrower proves to be safer when this ratio depicts a higher number. This rating will help in getting an estimation of the yield spread.

Debt – A More Inexpensive Form of Finance

Compared to the issuance of equity, a cheaper financing source is arrived at by the issuance of debt while securing external financing. The interest payments are fixed with corporate bonds and other similar forms of debt. The earnings are claimed in equity financing. A shareholder is likely to capitalize on all potential advantages of his earnings if his ownership stake is larger.

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