What is the Cost of Debt?

//What is the Cost of Debt?
What is the Cost of Debt? 2017-10-02T07:21:03+00:00

Definition: The cost of debt is the monetary price of servicing the interest and principal payments of obligations used to raise capital for a company. In other words, it’s the price companies pay to acquire and keep debt.

What Does Cost of Debt Mean?

What is the definition of cost of debt? The debt cost is an important financial concept for valuations, merger activity, acquisitions activity, and any event that requires the raising of debt. It is a cost that is used by a vast array of financial professionals to determine the optimal capital structure for a company, as well as the most efficient ways to fund and conduct certain aspects of a company’s operations.

The raising capital with debt financing is typically cheaper than equity financing in the long run of a growing company. The cost of debt formula is calculated by dividing Total Interest by Total Debt.

Let’s look at an example.

Example

Let’s say that a company is looking to finance an acquisition for $5,000,000. Investment bankers give the firm several options: 1) $1,000,000 loan at 2%, $3,000,000 at 7%, and $1,000,000 at 4%, or 2) $3,500,000 at 9% and $1,500,000 at 4%. The firm’s executives must decide which option is cheaper, and as both options are using 100% debt, calculating the debt cost would be ideal in this scenario.

For option one, the debt cost is calculated to be 5.4% ($1,000,000 x .02 + $3,000,000 x .07 + $1,000,000 x .04) / ($5,000,000), whereas option two is calculated to have a debt cost of 7.5% ($3,500,000 x .09 + $1,500,000 x .04) / ($5,000,000). Based on these debt cost calculations, the firm’s executives would choose option A, as they are paying a total of $270,000 per year, versus $375,000. The firm could use the difference of $105,000 in cash to pay down additional debt or reinvest in the business.

Summary Definition

Define Cost of Debts: Cost of debt means the price to service liabilities and obligations.