A company's cost of debt is the effective interest rate a company pays on its debt obligations, including bonds, mortgages, and any other forms of debt the company may have. Because interest expense is deductible, it's generally more useful to determine a company's after-tax cost of debt. Cost of debt, along with cost of equity, makes up a company's cost of capital.
Cost of debt can be useful when assessing a company's credit situation, and when combined with the size of the debt, it can be a good indicator of overall financial health. For instance, $1 billion in debt at 3% interest is actually less costly than $500 million at 7%, so knowing both the size and cost of a company's debt can give you a clearer picture of its financial situation.
Calculating cost of debt
In order to calculate a company's cost of debt, you'll need two pieces of information: the effective interest rate it pays on its debt and its marginal tax rate.
Many companies publish their average debt interest rate, but if not, it's fairly easy to calculate using the company's financial statements. On the income statement, you can find the total interest the company paid (note: If you're looking at a quarterly income statement, multiply this figure by four in order to annualize the data). Then, 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.
Keep in mind that this isn't a perfect calculation, as the amount of debt a company carries can vary throughout the year. If you'd like a more reliable result, then you can use the average of the company's debt load from its four most recent quarterly balance sheets.
Next, determine the company's marginal tax rate (federal and state combined). For most large corporations, the federal marginal tax rate is 35%, as this rate applies to all income over $18.33 million. State corporate income taxes range from 0% to 12% as of 2016.
Finally, to calculate the after-tax cost of debt, simply subtract the company's marginal tax rate from one and then multiply the result by the effective tax rate you found earlier.
To illustrate this concept, let's say that Company X paid $10 million in interest last year. Over the past four quarters, the company's debt obligations averaged $250 million. Dividing its interest paid by its average debt, then multiplying the result by 100, reveals an average interest rate of 4%.
If Company X's marginal tax rate is 40%, then we can calculate the after-tax cost of debt as follows: