Cost of debt
In one sentenceThe annual rate the business pays for financing funds, calculated on the outstanding amount, and sometimes adjusted for the effect of deducting financing cost for tax.
Simply put
Divide the annual financing cost by the average financing balance. If the business is subject to income tax and financing cost is deducted from its taxable income, the after-tax cost is lower than the stated cost.
It is one of the two components of the cost of capital, and you compare it with the return the project earns: financing is worthwhile if the project earns more than its cost.
Worked example
A company with a financing balance of 1,000,000 SAR paid an annual financing cost of 70,000 SAR, assuming a tax rate of 20% for illustration.
Cost of debt before tax70,000 ÷ 1,000,000 = 7%
Effect of the tax deduction7% × (1 − 20%)
Cost of debt after tax5.6%
Formula: Annual financing cost ÷ financing balance × (1 − tax rate)
Don't confuse it with
Cost of equityThe return the owners expect on their money; it is not written in a contract but is usually higher because their risk is greater.