Cost of debt (Kd)

The cost of debt (Kd) is the cost that a company has to develop its activity or an investment project through its financing in the form of credits and loans or debt issuance (see external financing).

Cost of debt (Kd)

When we talk about the cost of debt, we are referring to the monetary cost that a company has to face for borrowing. In other words, in the same way that there are production costs (employees, raw materials or warehouse rental), there are also costs associated with debt.

This cost depends mainly on several factors such as the value of the debt, taxes, applicable interest rate, etc. Factors, let it be said, which we will see later.

Characteristics of the cost of debt

The main features are:

  • It is an observable cost.
  • Easier to calculate than cost of capital.
  • The effective cost of debt after taxes is used.

Cost of debt formula

For the application of a loan, the company will have to pay a cost during a certain period, known as the interest rate . Likewise, if a company issues debt in order to finance itself, it will have to offer an attractive return to its investors to be able to place it in its entire issue.

The formula for calculating the cost of debt is as follows:

cost of debt (kd)

Where:

  • i = The interest rate applied for the financing obtained (kd)
  • t = Type of tax lien.

Debt cost valuation

The determination of the cost of the debt is fundamental to calculate the profit margin and the efficiency of the company in the investment of a project. Therefore, any formula that manages to reduce the cost of the debt and repay it in the shortest possible time, is an adequate form of financing to develop any investment project. In addition, it is necessary to take into account the type of tax levy in each country, since it affects the cost of debt of an investment.

weighted cost of debt

On the other hand, it is easy to obtain the cost of the debt once we extract it from the balance sheet of a company, since in it we have the information about the interest paid for the year and the market value of the debt and the cost of capital.

Where:

  • Kd = Cost of debt (i), is the interest rate at which the company obtains financing.
  • t = Type of tax lien.
  • D = Market value of debt.
  • V = Market value of debt + Market value of equity.

In this way, by calculating the quotient between these variables, we can know the weighted cost of debt, also known as Kd (weighted).

The cost of debt is one of the most transparent variables that exist to assess the situation of the company and analyze how it is managing its amortization model in a reasonable period of time in order to allow the quantification of the final total cost once it is complete the repayment period and the interest rate applied.

It is important to mention that commercial financing is excluded, including commercial creditors, commercial bills payable, and taxes accrued. The reason is because it usually has no cost, except when the established commercial deadline is breached.

Example

In this example we have a total current (€ 14,500) and non-current (€ 5,100) liabilities of € 19,600.

Suppose it is made up of a bond that pays a 5% coupon for € 5,100 (5,100 / 19,600 = 26% of liabilities), a short-term loan for € 8,500 (8,500 / 19,600 = 43.37%) that we pay 7% and a debt with suppliers of € 6,000 (6,000 / 19,600 = 30.61%) for which we pay 8%.

The Kd would be calculated as:

Kd = (5% * 26%) + (7% * 43.37%) + (8% * 30.61%) = 6.7857%.

company balance sheet