The cost of debt (Kd) is the cost that a company has to develop its activity or an investment project through its financing in the form of credits and loans or debt issuance (see external financing ).
The main features are:
It is an observable cost.
Greater ease of calculation than the cost of capital.
The effective cost of the after-tax debt is used.
By applying for a loan, the company will have to pay a cost for a certain period of time, known as the interest rate . Likewise, if a company issues debt to be able to finance itself, it will have to offer an attractive return to its investors to be able to place it in the entirety of its issue.
The formula for calculating the cost of the debt is as follows:
cost of debt (kd)
i = The interest rate applied for the obtained financing (kd)
t = Tax rate type.
Assessment of the cost of the debt
The determination of the cost of the debt is essential to calculate the profit margin and the efficiency of the company in the investment of a project. Therefore, any formula that manages to reduce the cost of debt and amortize it in the shortest time possible, is a suitable form of financing to develop any investment project. In addition, it is necessary to take into account the type of tax assessment of each country, given that it affects the cost of debt of an investment.
On the other hand, it is easy to obtain the cost of the debt once we extract it from the balance sheet of a company, since in this we have the information about the interest paid to the year and the market value of the debt and the cost of capital.
weighted debt cost
Kd = Cost of debt (i), is the interest rate at which the company obtains financing.
t = Tax rate type.
D = Market value of the debt.
V = Market value of debt + Market value of capital.
In this way, by calculating the quotient between these variables, we can know the cost of the weighted debt, also known as Kd (weighted).
The cost of debt is one of the most transparent variables that exists to assess the situation of the company and analyze how it is managing its amortization model in a reasonable period of time with the objective of quantifying the final total cost once complete the repayment period and the interest rate applied.
It is important to mention that commercial financing is excluded, which includes commercial creditors, commercial bills payable, accrued taxes. The reason is that it usually has no cost, except when it is not met with the established commercial deadline.
In this example we have a current liabilities (14,500) and non-current (5,100) total of € 19,600.
Let’s suppose that it is made up of obligations that pay a coupon of 5% for a value of € 5,100 (5,100 / 19,600 = 26% of the liability), a short-term credit for a value of € 6,000 (6,000 / 19,600 = 30.61%) that we paid 7% and a debt with suppliers of € 6,000 (6,000 / 19,600 = 30.61%) for which we paid 8%.
The Kd would be calculated as:
Kd = (5% * 26%) + (7% * 30.61%) + (8% * 30.61%) = 6.06%.