Cost of Debt: What It Means and Formulas — Transcript

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1. 0:00today we will talk about the cost of
2. 0:02debt and its
3. 0:03formulas this is a fundamental Concept
4. 0:06in finance that can help companies and
5. 0:08individuals understand the cost of
6. 0:10borrowing
7. 0:13money the cost of debt is the total
8. 0:15interest expense owed on a debt put
9. 0:18simply the cost of debt is the effective
10. 0:20interest rate or the total amount of
11. 0:22interest that a company or individual
12. 0:24owes on any liabilities such as bonds
13. 0:26and Loans this expense can refer to
14. 0:29either the tax or after tax cost of debt
15. 0:32the degree of the cost of debt depends
16. 0:34entirely on the borrower's
17. 0:35creditworthiness so higher costs mean
18. 0:38the borrower is considered
19. 0:42risky debt is any money owed by one
20. 0:45entity to another and is rather common
21. 0:47for companies and
22. 0:48individuals for corporations debt is one
23. 0:51part of their Capital structures which
24. 0:53also includes Equity the cost of debt
25. 0:56measure is helpful in understanding the
26. 0:58overall rate being paid by a company to
27. 1:00use these types of debt financing it can
28. 1:03also give investors an idea of the
29. 1:05company's risk level compared to others
30. 1:07because riskier companies generally have
31. 1:09a higher cost of
32. 1:13debt there are a couple of different
33. 1:15ways to calculate a company's cost of
34. 1:17debt depending on the information
35. 1:19available one way to calculate the cost
36. 1:21of debt is by using the formula for the
37. 1:23after tax cost of debt the risk-free
38. 1:26rate of return is the theoretical rate
39. 1:28of return of an investment with zero
40. 1:30risk most commonly associated with US
41. 1:32Treasury bonds a credit spread is a
42. 1:35difference in yield between a US
43. 1:37treasury bond and another debt security
44. 1:39of the same maturity but different
45. 1:40credit quality this formula is useful
46. 1:43because it takes into account
47. 1:45fluctuations in the economy as well as
48. 1:47company specific debt usage and credit
49. 1:49rating if the company has more debt or a
50. 1:52low credit rating then its credit spread
51. 1:54will be
52. 1:57higher for example say the risk-free
53. 2:00rate of return is 1.5% and the company's
54. 2:03credit spread is
55. 2:043% its pre-tax cost of debt is
56. 2:084.5% if its tax rate is 30% then the
57. 2:12after tax cost of debt is
58. 2:153.15% this is calculated by using the
59. 2:17risk-free rate of return and adding the
60. 2:19credit spread to get the pre-tax cost of
61. 2:21debt then multiplying it by to get the
62. 2:23after tax cost of
63. 2:26debt here are four key takeaways one the
64. 2:30cost of debt is the effective rate that
65. 2:32a company pays on its debt such as bonds
66. 2:34and Loans two the key difference between
67. 2:38the pre-tax cost of debt and the after
68. 2:40tax cost of debt is the fact that
69. 2:41interest expense is tax deductible three
70. 2:45debt is one part of a company's capital
71. 2:47structure with the other being Equity
72. 2:49four calculating the cost of debt
73. 2:51involves finding the average interest
74. 2:53paid on all of a company's debts hope
75. 2:56this would help thanks for
76. 2:58watching