The financial manager has to keep an eye on the interest rates, inflations, and exchange rates to provide helpful information about the financial market to the board members to make competent decisions.
Large and small organizations take loans from banks and investors and sell stocks to the shareholder to keep the business running.
The financial division generates a balance sheet and financial statements to review the cost of capital. The terms cost of debt and interest rates play an important role in measuring the cost of capital.
Key Takeaways
- The cost of debt is the total cost of borrowing funds, including interest, fees, and other expenses, while the interest rate is the cost of borrowing funds.
- Unlike the interest rate, the cost of debt considers the tax benefits associated with borrowing and is a more accurate measure of the true cost of borrowing.
- While the interest rate is determined by market forces such as supply and demand, the cost of debt is determined by the borrower’s creditworthiness and other factors such as market conditions.
Cost of Debt vs Interest Rate
Interest rate refers to the rate at which a lender charges a borrower for the use of money, expressed as a percentage of the loan amount. An interest rate is a contract between the lender and the borrower, and it remains constant throughout the life of the loan. On the other hand, the cost of debt is the cost of borrowing funds, including not just the interest rate but also other costs such as origination fees and loan discount points. It is the weighted average of all interest rates a company pays on its debt and is used to evaluate the profitability of new investments.
The cost of debt is the average amount paid on the loans or bonds taken by the company.
The financial manager calculates the cost of debt when the company plans to procure new debt from the investors to guarantee the security of the bonds and show the company’s financial performance to the investors.
The interest rate is the minimum rate paid on the principal amount, either monthly or yearly. The interest rate is spent on outstanding debts and new debts.
The interest rates changes as per the change in the market condition and the inflation rates, and Banks charge different interest rates for different types of loans.
Comparison Table
| Parameters of Comparison | Cost of Debt | Interest Rate |
|---|---|---|
| Definition | The cost of debt is the overall debt the company must pay to the creditors. | Interest rate is the percentage of the principal amount charged by the lender of money for using his money. |
| Declared by | The cost of debt is calculated by the company and distributed among the investors every year. | Investors, banks, and other financial institutes charge the Interest rate. |
| Outstanding debt | The cost of debt is not calculated on outstanding debts but on new debts. | Interest rate calculation includes the outstanding amount, the principal amount, and the period. |
| Interest rate | The cost of debt requires a current interest rate per investors’ demand. | The interest rate for a principal amount will be fixed at the time of borrowing. It will not change as per the market condition. |
| Factors Affecting | Interest rates and long payback periods will affect the cost of debt. | Credit score, bond length, inflation, loan type, and others. |
What is the Cost of Debt?
The cost of debt is the yield rate or the return on the investment given to the creditor for funding in the company. It is paid annually and given to investors to ensure their money is used correctly.
The cost of debt is one of the components of the cost of capital used to measure the company’s financial performance.
The cost of debt is calculated on the current market interest rate and not on the previous interest rate when taking the debt from the same creditor or other creditors.
The cost of debt is the amount before the tax is paid.
The cost of debt for new debt is calculated by dividing the interest expenses by the average interest rate.
The actual cost of debt is the after-the-tax cost obtained by multiplying the yield to maturity with one minus tax rate.
Companies use the after-the-tax cost of debt to calculate the weighted average cost of capital because the company’s stock price depends on the tax rates.
The tax cost of debt will help the company gain the investors’ trust and attract them to invest in its projects.
What is the Interest Rate?
Interest rate is the percentage rate the bondholder charges on the principal for using his money. It is either paid annually or monthly.
The interest rate differs for loans like business, home, educational, asset, government, project, etc.
The company lends financial institutions or outside investors money to invest in its business growth or projects. Investors charge lower interest rates than financial institutes.
The rate of interest rate depends on the type of loan. The interest rate of Short-term loans is less than long-term loans.
The interest rate gets influenced by government policies, market conditions, and inflation rates. The interest rates are directly proportional to the inflation rates.
The financial manager has to be updated with the changes in external factors and maintain good relationships with banking institutes and investors to provide effective information to the board members to rain the capital.
The financial manager has provided financial statements and cash flow information to the investors and stockholders to attract them to invest in the company.
Main Differences Between Cost of Debt and Interest Rate
- The cost of debt is the minimum amount determined on the company’s overall debts that must be paid to the creditors for raising new debt. In contrast, the interest rate is the percentage rate on the principal amount that must be paid to the creditor monthly or yearly.
- The cost of debt is calculated and decided by the company, and the financial institute or investor decides the interest rate on the bond.
- The cost of debt is calculated on the new debt when the company decides to raise capital, and the outstanding debt is not considered. In contrast, the interest rate calculation includes the outstanding debt amount, principal amount, and period.
- The cost of debt depends on the interest rate and the tax rate, whereas the interest rate is fixed for a bond.
- Factors affecting the cost of debt are interest rate and the period of debt, whereas the interest rate is a credit score, loan type, and inflation rates.
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3197415
- https://books.google.com/books?hl=en&lr=&id=9OUXEAAAQBAJ&oi=fnd&pg=PP1&dq=Fundamentals+of+Financial+Management,+Concise+Edition,+8th+ed&ots=CllEwUzbK2&sig=ioKPaQyrcEgl_MXMP7GEqBg5u1E
Last Updated : 13 July, 2023
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
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