Depending on the information accessible, there are a few different approaches to assessing a company’s cost of debt. Generally, there are two methods to calculate the cost of debt, depending on whether you are considering it as a pre-tax or post-tax cost. Businesses can raise cash for free cash flows via two methods, namely through equity capital and debt.
It reflects the current level of interest rates and the level of default risk as perceived by investors. Interest paid on debt is tax deductible by the firm; in bankruptcy, bondholders are paid before shareholders as the firm’s assets are liquidated. Default risk, the likelihood the firm will fail to repay interest and principal on a timely basis, can be measured by the firm’s credit rating. Default rates vary from an average of 0.52% for AAA-rated firms over a 15-year period to 54.38% for those rated CCC by Standard & Poor’s Corporation. Companies can raise money by selling stock, or ownership shares, of the company. The cost of common stock capital cannot be directly observed in the market; it must be estimated.
2 The Costs of Debt and Equity Capital
Those interest rates may not represent the company’s future borrowing power. The market value of debt can be estimated using a company’s debt totals reported on recent balance sheets. One common method is adding current cost of debt your company’s total interest expense for each debt for the year, then dividing it by the total amount of debt. The total cost of debt is influenced by the interest rate on each loan the business takes out.
You also know how to use Microsoft Excel or Google Sheets to automate the calculations. Using a tool like Layer, you can automate the process even further by synchronizing data across multiple formats and locations, as well as scheduling updates, assigning tasks, and automatically sharing reports. The owners of the bonds will also receive the $100 face value when the bonds mature in 18 years.
The Risk of the Company Stock
The higher credit ratings or cost of debt tend to follow companies with higher risk levels. To entice investors, bond offerings include interest payments, coupons, or, if it makes more sense, dividends. These payments encourage investors to take the risk of the investment. Cost of equity is calculated using the Capital Asset Pricing Model , which considers an investment’s riskiness relative to the current market.
How do you calculate bond cost of debt?
The formula for calculating the cost of debt is Coupon Rate on Bonds x (1 – tax rate). Most companies seek to establish a balance of equity and debt financing in order to maintain creditworthiness and control over the company's finances.