Business owners often finance their businesses through bonds when they are not lucky enough to be the target of any venture capital firms. Typically this is because of the flexibility they offer in terms of borrowing terms. They are inexpensive, easier to calculate and low-risk compared to other forms of financing. It is important however, that you learn the proper method of repayment. This will ensure that you are able to maintain good financial health. If you are a business owner interested in financing through bonds, you need to be familiar with the basics behind calculating the “cost of debt.” Cost of debt is the rate at which you pay off your debt. This post will provide you a quick guide on how to calculate the cost of debt for your business.
Learn The Basics Behind Debt-Financing
Before you go on to start calculating your cost of debt, you need to understand the basics behind debt-financing. This will give you a better grasp of what you are getting into. Firstly, you should know that bonds are usually given to companies that want to borrow large sums of money. They are bought by investors in exchange for cash. The borrower then pays the investor back the principal plus interest. Market interest rates fluctuate for bonds. However, this only affects the investor. The interest rate you are paying will not change. Once you understand this, you will be better prepared to calculate cost of debt.
Preferred stocks are a mix of stocks and bonds. These types of stocks are considered equity security. However, they are very similar to debt instruments and share many characteristics. Preferred stock is always issued with a fixed par value. These stocks pay dividends to the investor based on a percentage of that fixed par. Cost of debt is closely related to preferred stock, so be sure to understand the concept.
Calculate The After-Tax Cost Of Debt
Fortunately, the interest you pay on your debt is actually tax-deductible. Therefore, your cost of debt calculation should come after you make the proper deductions. Ultimately, your cost of debt will equal the interest paid times one minus the deductible amount of interest payments. It is important that you calculate the after-tax cost of debt. This is what investors use to assess the financial stability of your company. With a more accurate cost of debt on hand, you can move on to the next step for calculating cost of debt to later calculate return on investment.
Determine The Corporate Tax Rate
Your corporate income tax rate will play a role in your cost of debt calculations. Be sure to find an accurate representation of this number. In general, your company’s tax rate will be based on your taxable income. The lower tax bracket that pays about 15% starts with the first $50,000 of earnings. The rate rises to about 35% as income increases. If you own a personal service corporation, you will be subject to a flat rate of 35%. After you have determined your corporate income tax rate, you must find one more number before finalizing this process.
Find The Adjusted Interest Rate
The last number you need to find before calculating the final cost of debt is the adjusted interest rate. This is a simple process that involves multiplying the interest rate by 1 minus the corporate tax rate we found earlier. For example, if your corporate tax rate is 25% and your interest rate is 5%, the equation would be .05 x (1 – .25). With this, you can start making the final calculations for your cost of debt.
Calculate The Cost Of Debt
You now have your after-tax cost of debt, corporate income tax rate and adjusted interest rate. Now you are finally able to calculate your annual cost of debt using fixed expense figures. To do this, you need to multiply your after-tax interest rate by the principal amount of debt. For example, if your principal amount of debt was $100,000 and your after-tax interest rate is 5%, the equation would be 100,000 x .05. Your annual cost of debt would thus be $5000. If you followed all the steps up to this point, you will have successfully calculated your cost of debt.
Calculating your cost of debt is extremely important for organizing your finances. You will want an accurate representation of how much you owe per year. This can affect your level of capital, which would consequently affect your business operations as a whole. Calculating cost of debt is a multi-step process. It requires a firm understanding of what and how certain numbers need to be calculated. If you need help in this regard, refer to the steps laid out in this post. You will be able calculate your cost of debt in no time.
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