What is Cost of Debt and WACC?
Oct 18
/
themodelingschool
What is Cost of Debt?
The cost of debt is the effective interest rate that a company pays on its borrowed funds. It represents the rate that a company must pay to its lenders for the use of their money. The cost of debt is a crucial component of a company’s overall financing cost, as it directly impacts the company’s profitability and financial health.
In simple terms, cost of debt is the interest expense that a company incurs on its outstanding debt, which can include loans, bonds, or other forms of borrowing. Unlike equity, debt financing requires regular interest payments, and in most cases, the interest paid on debt is tax-deductible, reducing the actual cost to the company.
How to Calculate the Cost of Debt
The cost of debt can be calculated by taking the interest expense paid on debt and adjusting it for tax benefits. The formula is:
Cost of Debt (after tax) = Rd * (1 - Tc)
Where:
- Rd = Interest rate on the company's debt
- Tc = Corporate tax rate
For example, if a company has an interest rate of 5% on its debt and the corporate tax rate is 30%, the after-tax cost of debt would be:
Cost of Debt = 5% * (1 - 0.3) = 3.5%
This means that, after accounting for the tax shield, the effective cost of borrowing is 3.5%.
The Importance of Tax Shield
One of the reasons why debt is often considered cheaper than equity is the tax shield—the reduction in taxes that a company experiences as a result of interest payments being tax-deductible. The tax shield lowers the actual cost of borrowing, making debt an attractive source of capital for many companies. The greater the corporate tax rate, the larger the tax shield, and hence the lower the cost of debt.
How Do We Assume Cost of Debt in WACC?
The Weighted Average Cost of Capital (WACC) is the average rate that a company is expected to pay to finance its assets, considering both debt and equity. The cost of debt plays a significant role in determining WACC, as it influences the overall cost of capital.
The WACC formula is as follows:
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)
Where:
- E = Market value of equity
- D = Market value of debt
- V = Total value of capital (E + D)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
In the WACC calculation, the cost of debt (Rd) is adjusted for the corporate tax rate using (1 - Tc), reflecting the tax-deductibility of interest payments.
Key Considerations for Assuming Cost of Debt
When calculating the cost of debt for WACC, companies generally consider the following:
1. Current Market Interest Rates:
Companies may use the prevailing market interest rates to estimate the cost of new debt. This is often more reflective of current financing conditions and helps in assessing the cost of raising additional debt.
2. Weighted Average Interest Rate:
If a company has multiple loans or bonds with different interest rates, the weighted average interest rate is used to determine the overall cost of debt. This approach takes into account the different amounts borrowed at different rates to provide a realistic estimate of the total cost of debt.
Example: If a company has $1 million in debt at 4% and $2 million in debt at 6%, the weighted average interest rate would be:
(1,000,000 * 4% + 2,000,000 * 6%) / (1,000,000 + 2,000,000) = 5.33%
3. After-Tax Cost:
Since interest payments are generally tax-deductible, the cost of debt used in WACC is always the after-tax cost. This means the cost of debt is reduced by the corporate tax rate, providing a more accurate representation of the true cost to the company.
Example: If the interest rate is 6% and the corporate tax rate is 25%, the after-tax cost of debt used in WACC would be:
6% * (1 - 0.25) = 4.5%
Why Does Cost of Debt Matter in WACC?
The cost of debt is important in the WACC calculation because it reflects how much it costs the company to borrow money. Since debt is generally cheaper than equity due to the tax shield and lower risk for debt holders, incorporating the cost of debt in WACC can lower the overall cost of capital.
- Lower WACC: Including debt in the capital structure usually reduces WACC, as debt is typically cheaper than equity. This makes the company more competitive in pursuing new projects or investments.
- Risk Assessment: The proportion of debt in the company’s capital structure affects financial risk. A higher debt proportion increases the company's financial leverage, which can amplify both gains and losses.
Example of Cost of Debt in WACC Calculation
Let’s consider a company with the following information:
- Market Value of Equity (E) = $800,000
- Market Value of Debt (D) = $400,000
- Cost of Equity (Re) = 10%
- Cost of Debt (Rd) = 5%
- Corporate Tax Rate (Tc) = 30%
First, calculate the total value of capital (V):
V = E + D = $800,000 + $400,000 = $1,200,000
Now calculate the weights of equity and debt:
- E/V = $800,000 / $1,200,000 = 0.67
- D/V = $400,000 / $1,200,000 = 0.33
Now plug these values into the WACC formula:
WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc)
WACC = (0.67 * 10%) + (0.33 * 5% * (1 - 0.3))
WACC = 6.7% + 1.16% = 7.86%
The company’s weighted average cost of capital, incorporating the after-tax cost of debt, is 7.86%.
Conclusion
The cost of debt is an essential part of a company’s financial health, representing the interest rate paid on borrowed funds. When calculating WACC, the cost of debt is always considered on an after-tax basis to account for the tax benefits of interest payments. By understanding and incorporating the cost of debt effectively, companies can make better financial decisions, optimize their capital structure, and assess the viability of new projects.
