Cost of debt capital is associated with the amount of interest that is paid on currently outstanding debts. In the broadest sense, this can apply to all types of interest, including interest charges that are associated with revolving charge accounts. Most commonly, cost of debt capital is understood to be the interest that is paid on bank loans, bond options, and similar types of financial transactions.
Understanding the cost of debt capital is important to companies of all sizes for several reasons. First, obtaining the best interest rate possible is simply a good way to manage available finances. Understanding that the interest rates that apply to one or more business loans that are currently active can help a company determine if it is in the best interests of the business to seek a consolidation loan that carries a lower rate of interest than the existing loans. At the same time, evaluating the cost of debt capital on the current loans may indicate that leaving things as is 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 corporation to weigh the benefits of the potential action with the liabilities. By factoring in the cost of debt capital that will be accrued during the life of a business loan, it is possible to determine the true cost to the company of taking the action, versus finding some other way to achieve the intended goal.
Third, evaluating cost of debt capital can help a company determine if the issuance of a bond issue is the best move for financing an upcoming project. Bonds usually pay some amount of interest to the investors who purchase the bond issues. By projecting the rate of interest that will be paid out to bondholders during the anticipated life of the bond, it is possible to decide if issuing the bond is the best way to raise the funding, or if other alternatives should be considered.
