Personal Finance

# How To Calculate Cost Of Debt In The Singaporean Context: Unlocking Financial Success

October 6, 2023

# Understanding the Cost of Debt and Financial Metrics in Singapore

Table of Contents

## Introduction

Understanding the cost of debt in a business environment, especially in Singapore, is crucial for both small businesses and large firms. This article aims to clarify the cost of debt, how to calculate it, and its impact on a company’s financial standing. We will also delve into the after-tax cost of debt, the formula used, and how tax considerations play a role.

## What Is The Cost of Debt?

Cost of debt refers to the interest payments that a company or firm has to pay. In essence, the cost of debt can be defined as the aggregate interest or prevailing interest obligation incurred by a firm or borrower concerning their liabilities, including a loan and bond.

This cost of debt might pertain to the pre-tax or after-tax debt expense. The magnitude of loan expenses is contingent upon a borrower’s creditworthiness. Elevated charges indicate a heightened risk associated with the borrower.

### Key Takeaways

Here are some key takeaways to help us understand better:

- The actual interest rate payable by a company on its loan or bond is referred to as the debt cost.
- The primary distinction in pre-tax vs after-tax cost of debt lies in the tax-deductible nature of interest expenses.
- Debt constitutes a component of a firm’s capital structure alongside equity capital.
- Calculating the cost of debt entails computing the mean interest rate incurred on all liabilities a firm holds.

### Understanding Debt Definition And Debt Cost In Singapore

#### Debt Definition

Debt refers to the financial obligation incurred by a borrower to a lender. Incurring debt is inevitable for several organisations and is a common phenomenon. Indeed, both corporations and people have the option to utilise debt as a means to facilitate substantial acquisitions for fostering subsequent expansion.

#### Role Of Debt In A Company’s Capital Structure

In the context of business entities in Singapore, namely corporations, debt constitutes a component of the company’s capital structure alongside equity capital. The concept of capital structure pertains to how a company secures financial resources to support its overall business activities and expansion initiatives. This encompasses a variety of funding channels, such as debt instruments like a loan or bonds.

#### How Cost Of Debt Indicates A Company’s Risk Level

The debt cost metric is a valuable tool for comprehending the aggregate rate incurred by a firm when utilising financing of debt. The metric can additionally provide investors with insights into the comparative company risk level, as companies with higher risk profiles typically exhibit elevated debt costs.

### Calculating Debt Costs

Depending on the data, a few approaches can be used to determine a company’s debt cost.

#### After-tax Debt Formula Tailored To Singapore’s Tax System

To get a sense of how much borrowing will set you back, you can use the following after-tax debt formula:

After-Tax Debt Cost = (Credit Spread + Free Risk return Rate) x (1 – Rate of Tax)

#### Explanation Of Risk-free Rate Of Return And Credit Spread In Singapore

The Free Risk return Rate refers to the hypothetical tax treatment of interest on an investment without risk. This concept is usually linked to U.S. bonds.

On the other hand, credit spread refers to the disparity in interest rates of U.S. bonds and a different debt security with a similar duration but varying creditworthiness.

The method mentioned above proves advantageous due to its consideration of economic swings and incorporation of the company’s particular debt use and rating. Assuming a corporation in Singapore possesses increased debt or exhibits a lower credit rating, the credit spread elevates.

As an illustration, let us assume that 1.5 is the risk-free rate of return, and 3% is the company’s credit spread. The debt pre-tax will be 4.5%. Assuming a tax rate of 30%, the debt after-tax cost will be 3.15%.

#### Debt Calculation Method For Cost Before Tax For Singaporean Companies

An alternative debt calculation method involves ascertaining the aggregate sum of interest disbursed on every debt over a year.

Interest incurred by a corporation for its debts encompasses the credit spread and the no-risk tax savings from interest on return, as indicated in the calculation above. This is because lenders consider both factors when initially establishing the interest.

After completing the annual interest payments, the corporation calculates the ratio by dividing the sum by the aggregate amount of its outstanding debt. The figure denotes the mean interest rate of the company’s whole debt portfolio.

### Singapore’s Taxes’ Effect On Debt Cost

The effective cost of debt a borrower pays is reducible by tax payoffs for taxes still owed from obligations. Interest paid on debts is generally considered favourable under tax regulations.

Interest paid on debt is the debt pre-tax before subtracting the income tax from deducting interest payments. You determine the debt cost after taxes by dividing the effective tax by one and multiplying the result by the total amount of debt.

Disregard the marginal rate. To get the effective rate of a company, add the rates a company is taxable at the federal and state levels.

### Debt Reduction Strategies In Singapore

Saving money is a top priority for businesses and individuals in Singapore. The objective is to ensure low costs and high income. Here are the debt reduction strategies in Singapore.

#### Negotiating Rates With Singaporean Banks

Consider the circumstances and try to negotiate a lower price. Several creditors will provide an upfront rate.

However, you are not required to agree with the price they provide. If you are ready to take the initiative to negotiate, several creditors may collaborate with you and offer a cheaper one since they’re after your company.

#### Refinancing Options Available In Singapore

If interest decline or circumstances change, and you can get a preferable rate, consider refinancing. Mortgage borrowers frequently take this action when rates decrease.

#### Increasing Payments To Reduce Interest

Your principal balance will decrease if you make monthly excess payments. It can lower the total interest required to complete the loan.

#### Improving Credit Scores

The rate you receive depends on the credit score you have. You’ll pay a greater fee for having a poor score.

Your rate will go down if you raise your score. Paying your payments and eliminating outstanding debt are two ways to do this. Make careful periodic checks on your report to ascertain no mistakes are made.

### Example Of Cost Of Debt In Singapore

Let’s say you’re the boss of a small company that uses two different forms of debt financing. The first option is to borrow $250,000 from a reputable bank.

The second source of funding is a Private investor loan of $150,000. The interest rate on the initial loan is 5%, while that on the second loan is 4.5%.

Let’s start by figuring out how much interest you’ll spend a year on the two loans together:

First Loan: 5% multiplied by $250,000 amounts to $12,500.

Second loan: 4.5% multiplied by $150,000 amounts to $ 6,750.

Calculate the aggregate interest by adding the two values above to $19,250.

This amount is then divided by the total debt balance to yield the before-tax effective rate:

$19,250 divided by $400,000. You will get 0.0481.

So, 4.81% is the effective rate of these loans before taxes.

### Additional Considerations For Singapore

**Reasons For Cost Debt In Singapore?**

Borrowers must repay the initial loan amount, interest, and additional funds borrowed. The interest, also known as the yield, is the debt cost.

It compensates the lender for the loan’s risk of default, hike, and the time value of money (TVM). There are also ‘opportunity costs’ related to the borrowed and not invested money.

**Factors Increasing The Debt Cost In Singapore**

The loan interest rate increases when the lender perceives a higher risk level. One of these is a more extended repayment period, which increases the loan’s opportunity cost.

As there is an increased likelihood of defaulting and the creditor not being repaid in whole or part, the debt cost rises as the borrower’s riskiness rises. The interest rate on a loan reduces when a borrower pledges collateral as security, while the rate on an unsecured loan is higher.

**Difference Between Debt Cost And Equity Cost In Singapore**

Businesses in Singapore can get the funds they require daily from debt and equity capital. Companies might expect a higher cost and less favourable tax treatment from equity funding.

However, if a company takes on excess debt, it can hurt its credit and put it in greater danger of bankruptcy. Therefore, businesses aim to minimise their WACC by strategically allocating their equity and debt capital.

**Understanding The Debt Agency Cost In Singapore**

Agency cost of debt refers to the tension among the debtholder(s) and shareholder(s) and in a public corporation. This happens when the latter imposes restrictions on the former’s ability to deploy money out of concern that management would prioritise equity owners over them.

Debt holders in Singapore may restrict money expenditure to protect their investment by ensuring they meet specific financial targets.

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**Bottom Line**

Most individuals and organisations in Singapore will inevitably take on some form of debt to finance expansion or make large acquisitions. However, knowing the mechanism behind it is crucial. You are responsible for the main balance and the interest accrued on that debt, known as the interest rate on loan.

To calculate the debt cost, multiply the principal amount borrowed by the annual interest rate. To calculate your effective interest rate, multiply your total interest payments by the principal amount of your debt.