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The effective interest rate that a company has to pay towards its debt borrowings is known as the cost of debt. Debt borrowings mostly include bonds and loans. The cost of debt can have before-tax or after-tax considerations. The primary difference is the tax-deductibility of interest expenses.
Cost of Debt = Interest Expense(1 – Tax Rate). Suppose, Vareto took out a loan of $200,000 at an interest rate of 8%. Interest expense is $16,000 and the tax rate applicable is 30%. Thus, cost of debt = 16,000(1-30%) = 16000(0.7) = $11,200
Before borrowing new debt, companies must take into account the applicable cost of debt and the potential income growth that the debt will facilitate. A low cost of debt may be considered for a business expansion that could fetch twice the amount of revenues (vis-a-vis the cost of debt) in the first year of operations. In case of a high cost of debt, businesses can consider delaying growth until the existing debt is cleared and the cash flow situation is improved.
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