Businesses can cost a lot of money to start-up and to keep running. It’s often that business owners are forced to take out loans or use credit cards to pay for operating expenses or to have their venture realized. These third-party lenders don’t exist to just help people out (although that would be nice and quite utopian), they are a business just like you that thrive off of interest accrued from your outstanding debts. Interest rates vary due to the amount owed, the repayment time line and the lender from which you are borrowing. Rates also depend on the market and as such are in a constant state of flux. Additionally, every company falls into a tax-bracket that dictates what percentage of income taxes are due annually. Learn how to prepare Basic Income Taxes in this tutorial.
The Cost of Debt
When you incur these debts from outside financial institutions the interest paid on the loan is considered your cost of debt. Companies use the cost of debt to measure the overall interest being paid on bonds, loans and credit cards to measure their average rate being paid. Calculating this rate is useful when assessing debt financing. The higher your cost of debt, the “riskier” your business is in the eyes of investors. To get the cost of debt the accountant would find the sum of total debt and divide it by the number of current loans. This figure is your loan weight. You then multiply each weight by the interest rate associated with each loan and add those figures together to get your cost of debt Weighted Average Cost of Capital (WACC). Let’s demonstrate this further.
Let’s assume that you run Mark’s Lemonade. Marks Lemonade has three loans one for $5,000, one for $10,000 and one for $15,000. The interest’s rates on these loans are 3%, 4% and 5% respectively. The total amount the company is in debt is the sum of these three loans:
$5,000 + $10,000 + $15,000 = $30,000
Now you will take each loan and divide it by the total amount owed to get your weights:
$5,000/$30,000 = .16 $10,000/$30,000 = .33 $15,000/$30,000 = .5
Next, you want to take the weights and multiply them by their associated interest rate fees:
.16 x .03 = .005 .33 x .04 = .132 .5 x .5 = .025
So your weights are .005 (.5%), .132 (1.32%) and .025 (2.5%). To get the cost of debt WACC add these weights together:
.5% + 1.32% + 2.5% = 4.32%
This means that $4.32 of every dollar financed goes to paying interest. For more financing tools you can use to calculate every aspect of your business finances, check out the course Finance and Accounting for Start-Ups.
After-Tax Cost of Debt
So now we know that for every dollar the company owes, $4.32 is actually going towards paying interest rates. So how much does debt costs when we plug in tax benefits associated with certain kinds of debt? For a mortgage the IRS lets your deduct interest and some investment interest can be used to balance your investment income. Learn how to analyze a financial statement in this course. Now, let’s figure out how much a debt really costs by using Mark Lemonades stand again.
Your business falls into the 30% tax-bracket (based off of total revenue) and you currently are indebted $30,000 with an annual repayment plan. The interest rate on this debt is a mediocre 10% which means on an annual basis you are paying $3,000 in interest to your lender(s). Your annual revenue is recorded at $102,000. Subtract your deductions from your income by looking on your finance statement under deductions. Mark’s Lemonade has deductions of $2,000 so the total taxable income is $100,000. Learn more about interpreting financial statements in this online tutorial so you ensure these numbers are accurate.
So here’s how to do the calculation:
First, convert your tax-bracket percentage to a decimal, for 30% this would .30. Now, subtract your tax percentage from 1.
1 – .30 = .70
Now, you want to multiply your interest rate by the marginal tax rate, .70:
.70 x .10 =
When laid out the entire formula looks like this:
[interest rate X (100% – tax rate)] = after-tax cost of debt x 100
[.10 x (1-.30)] = .07 x 100 (7 or 7%)
So, Marks Lemonade’s after-tax cost of debt is $2,100 or 7% of the total loan amount of $30,000. It seems a little complicated, and I suppose it can be the first time you do it. However, after you understand the process this will be just another quick tool you can use to measure your debt financing. Or, if you’re in the market for a good software program to do all of you money managing and calculating for you – read Best Money Management Software to help guide you.