The cost of debt capital refers to the interest paid on outstanding debt, including bank loans and bond options. Understanding it helps businesses manage finances, weigh potential actions against liabilities, and determine the best way to raise funding.
The cost of debt capital is associated with the amount of interest paid on currently outstanding debt. In the broadest sense, this can apply to all types of interest, including the interest expense associated with revolving debit accounts. Most commonly, the cost of debt capital refers to the interest paid on bank loans, bond options, and similar types of financial transactions.
Understanding the cost of debt capital is important to businesses of all sizes for several reasons. First, getting the best interest rate possible is simply a good way to manage your available finances. Understanding the interest rates that apply to one or more currently active business loans can help a business determine whether it is in the best interests of the business to seek out a consolidation loan that has a lower interest rate than existing loans. At the same time, assessing the cost of debt capital on outstanding loans may indicate that leaving it at that would be the best option.
Second, calculating the cost of debt capital as it applies to incurring more debt through loans or other sources can help the company weigh the benefits of potential action against the liabilities. By considering the cost of debt capital that will accrue over the life of a business loan, you can determine the actual cost to the business of taking the action, rather than finding another way to achieve the intended goal.
Third, assessing the cost of debt capital can help a company determine whether issuing a bond issue is the best move to finance an upcoming project. Bonds usually pay a certain amount of interest to investors who buy the bond issues. By projecting the interest rate that will be paid to bondholders over the expected life of the bond, you can decide whether issuing the bond is the best way to raise funding or whether other alternatives should be considered.
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