The cost of debt capital is the interest paid on outstanding debts, including bank loans and bonds. Understanding it helps businesses manage finances, consolidate loans, and evaluate potential actions. It can also help determine whether issuing a bond is the best way to raise funds.
The cost of debt capital is associated with the amount of interest paid on currently outstanding debts. In the broadest sense, this can apply to all types of interest, including interest charges associated with revolving charge accounts. More commonly, the cost of debt capital is understood to be the interest paid on bank loans, bond options, and similar types of financial transactions.
Understanding the cost of debt capital is important for businesses of all sizes for a number of reasons. First, getting the best possible interest rate is simply a good way to manage your available finances. Understanding the interest rates that apply to one or more business loans that are currently active can help a business determine whether it is in the best interest of the business to seek a consolidation loan that has a lower interest rate than the loans existing. At the same time, evaluating the cost of debt capital on current loans may indicate that leaving things as they are would be the best option.
Second, calculating the cost of debt capital as applied to incurring more debt through borrowing or other sources can help the corporation weigh the benefits of potential action against the liabilities. By taking into account the cost of debt capital that will accumulate over the life of a business loan, it is possible to 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 generally pay a certain amount of interest to investors who purchase the bond issues. By projecting the interest rate that will be paid to bondholders over the expected life of the bond, it is possible to decide whether issuing the bond is the best way to raise funds, or whether other alternatives should be considered.
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