What is the cost of debt capital? A common calculation is 7% of a loaned amount multiplied by the interest rate. But what is the real cost of debt capital for businesses? Businesses often account for the corporate tax rate when determining the real cost of debt capital. For example, a company with a 30% corporate tax rate would have a cost of capital of 4.9%. In addition, debt payments are typically tax-deductible.
According to Joseph Stone Capital Most organizations don’t trade directly on the primary market, but instead approach an investment bank that specializes in debt capital management. These banks charge a fee for their services, and also may earn money from selling other services associated with debt capital. Here are some of the differences between debt capital and equity investments. The difference is not so great that a personal investor can’t make a business loan directly from a bank. Debt investors are interested in recurring revenue, interest coverage, and business risk, but are less concerned with growth potential.
While debt is a healthy part of personal finance, it can also be a problem in corporate finance. A business may need debt capital to get off the ground, but the key to managing debt capital is planning ahead. Debt capital can be difficult to access, and may require collateral to secure the loan. Nonetheless, if done right, it can help a business get off the ground. A business can use debt capital to get off the ground and improve its creditworthiness while paying off its debts.
The cost of debt financing is primarily due to hidden “agency” costs associated with covenants, indenture agreements, property mortgages, and performance guarantees. The cost of debt can be prohibitive if a company is heavily leveraged for growth. However, the cost of debt at market value is low, and typically does not exceed twenty to thirty percent of a company’s past market value. Further, the cost of debt can cause the company to alter its product and market strategies, which can reduce its market value.
As a business owner, you must be aware of the differences between equity and debt capital. While equity capital is a form of ownership in a company, debt capital is a loan. While debt capital is an asset, it requires repayment, so the risks are different for businesses. But the benefits are clear. Debt capital, whether short-term or long-term, is an essential source of funding for growth. However, it can be cumbersome to repay interest, especially if interest rates are rising.
Joseph Stone Capital advises Companies that struggle to get debt should first consider equity capital. Equity capital is easy to secure but requires that a business owner gives up a portion of its ownership. Small business owners generally do not like the idea of losing ownership of their business. However, debt capital allows business owners to retain ownership, and the payments are tax-deductible. Further, debt capital allows businesses to take advantage of low interest rates. Therefore, when choosing between equity and debt capital, be sure to consider the cost of the loan and the risk involved.