It’s not uncommon for the general population to view debt as an unfavorable financial instrument, but entrepreneurs and finance directors know the value of leveraging capital. In fact, smart business owners know how to use debt as an actual tool to grow their business.
Debt can be a critical device for businesses that know how to calculate the costs and benefits accurately. It’s important to understand how debt impacts a company’s bottom line so businesses can optimize their financial strategy. Calculating the after-tax cost of debt is one way business owners can determine how much value their debt provides.
Between equity financing and debt financing, businesses have an obligation to track their liabilities. With the many financing options available for businesses of all sizes, calculating the cost of debt can be complex. Review this step-by-step guide to the cost of business debt for an understanding of calculating the after-tax cost of debt.
Business Debt Factoring into After-Tax Cost of Debt
Before diving into calculations, it’s critical to know exactly what debt a business has outstanding. Debt is a broad topic though, and to get an accurate cost of debt, businesses need to include all of their outstanding liabilities. Though it will vary from company to company, there are common types of debt that most businesses incur.
With debt financing, institutional investors purchase financial instruments that pay a fixed interest rate until the product matures. The original investment is paid back at maturity, though extensions may be available. Companies that want to raise capital through fixed-income debt products have a few options.
- Certificates of deposit (CD)
- Corporate bonds
- Exchange-traded funds
- Municipal funds
- Mutual funds
- Treasury bills, bonds, and notes
In general, this is a relatively low-risk investment opportunity for firms that have substantial capital and want to see steady, stable returns. It’s the most conservative debt option for both parties.
Equity financing is a financial instrument that doesn’t have a return structure like debt financing. Investors purchase shares in a company with the expectation that they will receive dividends on their investment in the future. Investment can come from various creative sources:
- Business partners
- Family members
- Close friends
- Private investors
- Institutional investors
- Initial Public Offerings (IPO)
Since this doesn’t have to be paid back like other capital products, it’s an investment tool that offers significant value to businesses that need to raise a large amount of capital.
Small Business Loans
Entrepreneurs and small business owners can access loans that offer specific benefits to businesses in different stages of growth and development. Depending on how much capital a business needs and what kind of interest rate it’s willing to pay, the following types of small business loans are available to them:
- Installment loans
- Merchant cash advances
- Personal loans
- P2P loans
- Short-term loans
- SBA loans
Lenders may be able to approve businesses for these loans by reviewing their company’s credit history and financial information. Some loans may require a personal guarantee from an owner or director.
Commercial Real Estate Loans
Purchasing real estate can be both a cost-efficient expense strategy and a lucrative investment opportunity. Businesses that want to take advantage of purchasing or refinancing property can choose from several types of commercial real estate loans:
- Commercial bridge loans
- Commercial hard money loans
- Conventional commercial loans
- SBA 504 loans
- SBA 7(a) loans
Each of these commercial real estate loans offers different benefits to businesses. They also have different terms and cost structures, so it’s important to compare them wisely.
Revolving credit is often viewed as a financial instrument for consumers, but it can be an effective strategy for managing large purchases or monthly expenses. This credit is available to businesses at every stage and the most common types include:
- Charge cards
- Credit cards
- Invoice financing
- Lines of credit
- Net 30 accounts
Businesses make payments toward their balance to free up credit for future purchases. Revolving credit can range from relatively inexpensive to extremely costly, but it is readily available to businesses.
Small business loans are generally unsecured, so they are a bit riskier for financial institutions, but secured loans can provide confidence to lenders that may otherwise decline an application. Businesses need collateral for secured loans, which can come in different forms:
- Asset-backed loans
- Commercial property loans
- Commercial vehicle loans
- Equipment loans
Collateral can be real property or liquid assets. As lenders can seize the collateral, secured loans are generally easier to approve for businesses without a lot of credit or financial history.
Leasing equipment is one way that businesses can acquire the tools they need for success without investing all of their funds in costly equipment. It also gives businesses the flexibility to upgrade equipment in the future. Common types of equipment that businesses lease include:
- Computer equipment
- Heavy machinery
- Kitchen equipment
- Medical technology
Equipment leases usually have a cost. Instead of an interest rate, they have a lease rate. The costs for purchasing the equipment will vary, and businesses should include those costs in any calculations.
Net 30 Accounts
A net 30 account is similar to revolving credit accounts. Though the terms can actually vary from 30 days (think 7- 90 days), the principle is still the same: make a purchase, then pay it back in full before the end of the term. Net 30 accounts are common for products that businesses need to purchase routinely, like:
- Construction materials
- Creative services
- Office supplies
- Restaurant supplies
- Retail orders
With net 30 accounts, businesses can manage their regular purchases by ordering what they need and paying for the purchases before the term expires. Net 30 accounts may or may not have fees.
Mezzanine debt is financing for businesses that need more capital than a commercial lender can provide. It can be in the form of debt financing, equity financing, or a combination of the two. Mezzanine debt is generally a selection of convertible and non-convertible debt, including:
- Commercial real estate
Mezzanine debt tends to function more like equity financing, as businesses pay back the investment in ownership rights to the company rather than interest. It is typically an expensive form of financing.
Why Does a Business Need to Calculate Their After-Tax Cost of Debt?
Businesses that regularly leverage debt should already be calculating their after-tax cost of debt, but not every business is aware of the practical benefits of understanding the actual costs of debt financing. When looking at individual financing offers, it can be easy to focus on the cost of that particular piece of debt rather than the whole portfolio.
Most businesses, however, have more than one outstanding debt obligation, which means they need to invest a little more time in determining their cost of debt.
Calculating the after-tax cost of debt gives businesses practical insight. This includes the following:
- Tax savings: The most lucrative benefit of calculating a business’s after-tax cost of debt is the tax savings. A business that pays interest on their debt can deduct that amount from their taxes at the end of the year. This lowers the cost of capital and reduces the tax liability for many businesses.
- Rate comparisons: Understanding the cost of capital can help businesses make better decisions about future financing offers. They can determine which debts to consolidate, refinance, or payoff, and with this information, businesses can craft an efficient debt policy. This is especially important in the early stages of growth before finding an investor.
- Investor confidence: Any business that wants to acquire investors will need to know its cost of capital. Investors want to know how financially healthy businesses are and the after-tax cost of debt is one way to measure the overall risk factor for an organization. Though investors will consider other factors, this is a useful way to validate a company’s story.
Beyond this, it’s good practice to know how much debt costs as a portion of a business’s overall expenses. Businesses that use the right accounting tools can deduce their debt percentage of the organization’s costs. Leveraging debt can be a smart decision, but it needs to be done properly.
How to Calculate After-Tax Cost of Debt
If a business hands their financials over to an accountant, the accountant probably does this calculation for them. Calculating the after-tax cost of debt is something any business owner can and should do, though.
1. Compile a Consolidated List of Outstanding Debt.
This list needs to include all business debts that a company pays interest on. That includes any leases the company may have, as well as all secured or unsecured loans, credit cards, cash advances, lines of credit, or real estate loans. It should also include any loans that have a personal guarantee by the owner but are used for the business.
This list does not need to include general expenses, like rent or utility payments. It also shouldn’t include payroll expenses or equity financing, though that should be considered when calculating the total cost of capital.
2. Find the Associated Coupon or Interest Rates for All Debt.
Compiling a list of outstanding debt is relatively easy, but it’s not always clear how much businesses are paying for their debt. This list should include the individual cost of capital for each debt product. That means a business needs to find every interest and lease rate it pays for its financing products.
This is a good time to put together other debt information that can be helpful for future comparisons. Include the debt’s term, cost of additional fees, maturity date, and any other benefits the debt offers to the business. This can help narrow down future financing choices.
3. Figure the Effective Tax Rate for the Business.
The primary benefit of calculating the after-tax cost of debt is knowing how much a business can save on its taxes due to the interest it paid over the year. This means businesses need to know their effective tax rate to understand their total cost of debt.
Calculating the effective tax rate for a business is easy. For the purposes of the after-tax cost of debt, the effective tax rate is determined by adding the company’s federal tax rate and its state tax rate together. Depending on the state, that means some businesses may not have a federal or a state tax rate.
4. Determine the Pretax Cost of Debt.
Before a business can calculate the after-tax cost of debt, it needs to know how much it is paying for the debt before tax deductions are applied. Calculating the pretax cost of debt is simple:
- Pretax cost of debt = Interest rate on the debt instrument
This is a measure of how much a business is paying for its debt based on the lender’s criteria. That makes it a good measure of a company’s risk level and tolerance for other credit products.
5. Calculate the After-Tax Cost of Debt.
Now that a business has a comprehensive list of their outstanding debt and its costs, calculating the after-tax cost of debt should be quick. In fact, if all of this information is consolidated in a spreadsheet, businesses may be able to insert this formula in their list:
- After-tax cost of debt = Pretax cost of debt x (1 – tax rate)
An example of this is a business with a federal tax rate of 20% and a state tax rate of 10%. Their effective tax rate is 30%, or 0.3. The pretax cost of debt is 5%, or 0.05, and the business has a $10,000 loan.
- 05 x 0.3 = 0.015, or 1.5%
The pretax cost of debt is $500 for a $10,000 loan, but because of the company’s effective tax rate, their after-tax cost of debt is actually $150 for the same $10,000 loan. This makes a significant difference in a company’s total cost of capital.
Why is the After-Tax Cost of Debt Included in WACC Calculations?
Beyond the general benefits of calculating a company’s after-tax cost of debt, the information is critical to understanding how much a company pays for all of its capital. That means the cost of both debt financing and equity financing.
The weighted average cost of capital (WACC) is a calculation of how much a company should pay to finance the operation. It considers multiple variables though, so it’s not necessarily an accurate depiction of a firm’s total costs.
The after-tax cost of debt is generally included in WACC calculations for these reasons:
- Conveys financial health: Knowing how much a company owes in equity is one part of the WACC equation, but it doesn’t give the full picture of a company’s financial position. The after-tax cost of debt is a measurable indicator of a firm’s outstanding liabilities.
- Indicates growth strategy: Business growth is critical for companies that leverage debt, and investors want to know that businesses have a plan. The after-tax cost of debt indicates how much a business needs to earn to satisfy its equity and debt obligations.
- Encourages sound decision-making: It can be easy to take on new debt without considering the implications to investors. Sometimes debt is necessary to keep a business going. The after-tax cost of debt calculations shows investors that a business makes the right financial decisions.
The most difficult part of calculating WACC is determining a business’s equity costs. Due to some variables, including the stock market, this part is generally the estimate in the WACC calculation. That’s why the after-tax cost of debt is so critical to balancing WACC calculations.
The True Cost of Business Debt
Debt is a vital financial tool for many businesses. Small businesses rely on SBA loans and credit cards to manage their operations, and large corporations take advantage of commercial real estate loans and private equity financing to fund significant growth. These tools make it easier for businesses to thrive, but they come with a cost.
Every business should have a list of their outstanding liabilities and how much those debts cost. Even if a company isn’t planning to seek investors, the cost of debt is an important part of understanding how much money a company actually makes.
The after-tax cost of debt is a quantitative measure of how much a business is paying for its debt financing. This information offers valuable financial insight and practical investment figures that businesses can use to improve their financial position.