Cost of Debt

Concept

Cost of Debt ($R_d$) is a key concept in finance. It represents the effective interest rate a company pays on its debts. $R_d$ is important because it's used to calculate the Weighted Average Cost of Capital (WACC), which is a measure of a company's cost of capital that takes into account the relative weights of equity and debt. The lower the $R_d$, the less the company pays in interest, which can lead to higher profitability.

Formula

The formula for calculating the cost of debt ($R_d$) is as follows:

$$R_d = \frac{{\text{{Interest Expense}}}}{{\text{{Total Debt}}}} \times 100$$

In this formula:

• $\text{Interest Expense}$ is the total interest paid by the company in a given period.
• $\text{Total Debt}$ is the total amount of debt the company has. The market value of debt can be calculated by adding together the company's short-term and long-term debt.

Example

Let's say a company has an interest expense of $500,000 and total debt of $10,000,000. The cost of debt can be calculated as follows:

$$R_d = \frac{{\$500{,}000}}{{\$10{,}000{,}000}} \times 100 = 5\%$$

This means that the company's cost of debt is 5%. This is the rate at which the company is effectively paying interest on its debt.