Debt is one component of the business firm's capital structure and usually the cheapest form of financing for the company. Companies usually try to use as much debt financing as possible, without raising their risk too much, because of debt is inexpensive compared to the other forms of financing. Other possible forms of financing and components of the capital structure of the firm are preferred stock, retained earnings, and new common stock.
What is the Cost of Debt Based on?
The cost of debt is usually based on the cost of the company's bonds. Bonds are a company's long-term debt and are little more than the company's long-term loans. The cost of newly issued bonds is the best rate to use if possible when calculating the cost of debt.
If a company has no publicly-traded bonds, then the business owner can look at the cost of the debt of other firms in the same industry in order to get an idea of the cost of debt.
Calculate the Cost of Debt Capital
The cost of debt capital is not simply the cost of the company's bonds. Since the interest on debt is tax-deductible, you must multiply the coupon rate on the company's bonds by (1 - tax rate) to adjust for this as follows:
Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate)
Flotation costs or the costs of underwriting the debt are not considered in the calculation as those costs are negligible when it comes to debt.