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Jul 4, 2024

Cost of Debt: Definition, Examples, and How to Calculate?

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Ankit Virani

CEO

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Starting a business in India is exciting, but funding it can be a puzzle. One key piece? Understanding the cost of debt!

Simply put, the cost of debt is the interest you pay to borrow money. But in India, it's more than just a number on a loan agreement.

Government bonds set the tone for interest rates across the country. The type of loan you get, whether from a bank or a non-banking financial company (NBFC), also plays a role. The lower the cost of debt, the more affordable borrowing becomes for Indian startups.

Decoding the Cost of Debt

The cost of debt in India is more than just a number on a loan agreement. It's the total amount you, as a startup founder, pay to borrow money. Think of it like the final bill after all the fees are added. Here's why understanding the true cost of debt is crucial:

Interest Rate Breakdown:

  • Stated Interest Rate: This is the eye-catching number you see advertised, like 10% per year. It's a good starting point, but not the whole picture.

  • Effective Interest Rate: This is the real cost you'll pay. It factors in additional charges on top of the stated interest rate. These can include:

    • Processing Fees: A one-time charge levied by the lender to cover the cost of evaluating your loan application.
    • Prepayment Penalties: A fee you might incur if you pay off the loan early. This discourages borrowers from repaying quickly, as it reduces the lender's interest income.

Knowing these extra charges helps you compare loan offers accurately and avoid surprises. Factors Affecting Your Cost of Debt:

Now let's dive deeper into the things that influence how much you pay to borrow:

  • Your Credit Score: It's like a report card for your borrowing history. A good credit rating from CRIF High Mark signifies you're a reliable borrower, which translates to lower interest rates from lenders.

  • Interest Rate Environment: This refers to the overall level of interest rates in India. Two key factors play a role:

    • RBI Repo Rate: This is the rate at which banks borrow money from the Reserve Bank of India (RBI), the central bank. When the repo rate goes up, banks typically charge more for loans, and vice versa.
    • Government Bond Yields: These are the returns investors get for lending money to the government. If these yields are high, it can push up borrowing costs across the board. The higher these rates are, generally the more you'll pay for your loan.
  • Loan Details: The specific loan you choose also impacts the cost:

    • Loan Type: Term loans are for a fixed amount and repayment period while working capital loans are for ongoing business expenses. Each may have different interest rates.
    • Collateral: If you offer collateral, like property or equipment, as security for the loan, you might qualify for a lower interest rate. This is because the lender has something to recover if you can't repay.
    • Repayment Period: Generally, longer repayment periods come with slightly higher interest rates. This is because the lender's money is tied up for a longer time.
  • Government Schemes: Initiatives like MUDRA loans for startups can be a game-changer. These schemes offer easier access to funding and potentially lower interest rates compared to traditional loans.

By understanding these factors, you can negotiate for a better deal and choose the loan that best fits your startup's financial needs. Remember, a lower cost of debt means you keep more money in your pocket to fuel your business growth.

Also Read: Simplifying Income Tax Implications for Budding Entrepreneurs

Why Understanding Cost of Debt Matters

The cost of debt isn't just a number – it directly impacts your startup's success. Here's why understanding it's important:

  • Profitability Matters: Every rupee you pay in interest expense eats into your profits. The lower your cost of debt, the more money you have left to reinvest in your business and grow.

  • Financial Flexibility is Key: Debt can be a double-edged sword. While it fuels growth, a high debt burden can limit your ability to take on new opportunities. Knowing your cost of debt helps you manage your borrowing wisely and maintain financial flexibility.

Debt vs. Equity: Choosing the Right Funding Path

Every startup needs funding, but there are two main ways to get it: Debt and equity.

  • Debt Financing: You borrow money from a lender, like a bank, and agree to repay it with interest. It's like taking out a loan.
  • Equity Financing: You sell shares of ownership in your company to investors in exchange for cash. This gives them a stake in your company's success.

The cost of debt plays a big role in this decision, especially in India.

  • Debt can be cheaper than equity in the short term. Interest rates can be lower than what investors might demand for ownership in your startup.
  • However, debt comes with fixed obligations. You have to make those interest payments on time, even if your business is struggling. Equity financing, on the other hand, doesn't require fixed repayments.

The best approach often involves a mix of debt and equity. By understanding the cost of debt, you can make informed decisions about how to finance your startup's growth journey. Remember, the goal is to choose the funding option that gives you the capital you need while keeping your business healthy and flexible.

Calculating the Cost of Debt in India

So, you understand the importance of the cost of debt, but how do you calculate it in the Indian context? Here, we'll focus on the Indian After-tax Cost of Debt Method.

Why After-tax?

Interest payments on debt are considered a business expense in India. This means you can deduct them from your taxable income, lowering your corporate tax bill. The after-tax cost of debt considers this tax benefit.

The Formula:

The After-tax Cost of Debt is calculated using this formula:

After-tax Cost of Debt = Pre-tax Interest Rate * (1 - Corporate Tax Rate)

Let's break it down:

  • Pre-tax Interest Rate: This is the interest rate you're charged on the loan before any tax benefits are applied.
  • Corporate Tax Rate: This is the current tax rate that companies in India pay on their profits. As of July 2024, it's around 30%. (Note: This rate can change, so it's wise to check for the latest information)
  • (1 - Corporate Tax Rate): This represents the tax shield you get from the interest expense.

Also Read: GST Rules for Small Businesses and Start-ups in India

Example: Calculating Your Cost of Debt

Imagine you're a startup founder in India considering a loan with a pre-tax interest rate of 12%. The current corporate tax rate is 30%.

  • Step 1: Plug the numbers into the formula: After-tax Cost of Debt = 12% * (1 - 0.30)
  • Step 2: Calculate the after-tax cost: 12% * 0.70 = 8.4%

So, in this example, your after-tax cost of debt would be 8.4%. This means that after considering the tax benefit, your effective cost of borrowing is 8.4%.

Remember: This is a simplified example. Real-world calculations might involve additional factors like processing fees or prepayment penalties. However, this method gives you a good starting point for understanding your true cost of debt in India.

Making Debt Work for Your Startup

The cost of debt is a critical piece of the puzzle for Indian startups. By understanding it, you can:

  • Maximize profits: Lower borrowing costs mean more money to fuel growth.
  • Maintain flexibility: Manage debt wisely to avoid becoming financially stretched.
  • Make smart funding choices: Compare debt vs. equity based on cost and impact.

Use cost of debt analysis in your decision-making toolbox:

  • Capital budgeting: Evaluate projects considering the true cost of borrowing.
  • Debt vs. equity financing: Choose the funding mix that best balances affordability and ownership control.

Remember, a smart approach to debt empowers your startup's journey. Now you have the tools to make informed decisions and keep your business on the path to success.

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