Question

Explain how to calculate the effective cost of debt. Why is this metric important? Consider the impact on investment leverage as part of your answer.

Answer 1

Debt is one the most important ways in which a firm raises capital, the other being through equity.

The overall cost of capital is calculated through Weighted average cost of capital (WACC)

Weighted average cost of capital (WACC is the ratio that calculates the company’s cost of capital by comparing the debt and equity portion in the business

WACC = Cost of equity * Weight of equity + Post tax cost of debt * Weight of debt

A key point of raising capital through debt is that the interest expenses are tax deductible thus the overall cost of debt is reduced by taking tax into consideration

The effective interest rate is calculated as the Interest rate * (1 - tax rate)

Incase there are multiple loans through different interest rates a weighted average interest is taken and then it is multiplied by (1 - tax rate)

By taking leverage, the company can have benefits such as the overall cost of capital is reduced due to effective interest rate also the firm can expand i.e use that debt to further expand the business eg purchase of new machinery, purchase of equipment etc

However when a firm considers leverage it is extremely important to have returns which are more than the cost of capital. When the firm takes leverage it has to pay interest rate irrespective of the profitability of the firm. Excessive leverage can cause the firm into to go into bankruptcy