Question

Discuss when the cost of debt is different than the interest rate paid on debt and why it is different. Discuss how to calculate the cost of debt when it is different than the interest rate paid on debt.

Answer 1

Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection.

Debt capital does not dilute the company owner's interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising.

Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company's list of priorities over annual returns.

While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble.

The cost of debt is the rate a company pays on its debt, such as bonds and loans. The key difference between the cost of debt and the after-tax cost of debt is the fact that interest expense is tax-deductible. Cost of debt is one part of a company's capital structure, with the other being the cost of equity.

On the balance sheet, you can find the total amount of debt the company is carrying. Divide the annual interest by total debt and then multiply the result by 100, and you'll get the effective interest rate on the company's debt obligations.

To calculate the cost of debt, a company must determine the total amount of interest it is paying on each of its debts for the year. Then it divides this number by the total of all of its debt. The result is the cost of debt. The cost of debt formula is the effective interest rate multiplied by (1 - tax rate).