Cost of Debt
In short
The effective interest rate a company pays on its borrowings
If a company borrowed $1 million at 5% interest, its pre-tax cost of debt is 5%. But since interest payments are tax-deductible, the after-tax cost is lower — about 3.5% at a 30% tax rate, since the tax savings partly offset the interest actually paid out.
Cost of debt can be measured as the yield to maturity on a company's existing traded bonds (market-based), or estimated as a synthetic rate from the company's credit rating and the prevailing spread for that rating over the risk-free rate — useful when no public debt exists. Because interest is tax-deductible, the figure used in WACC is the after-tax cost of debt: pre-tax rate × (1 − marginal tax rate). This tax shield is one reason debt is typically cheaper than equity; debt holders also hold a senior legal claim on cash flows and assets, so they demand a lower return than equity holders for the same company. Cost of debt still rises as leverage increases, since more debt raises the risk of financial distress — beyond some point the higher rate can offset the tax benefit.
Formula
After-Tax Cost of Debt = Interest Rate × (1 - Tax Rate)Related concepts
- WACC — WACC is the average rate a company pays for all its funding — both equity (shareholders expect returns) and debt (banks charge interest). It's the minimum return a company must earn to create value.
- Debt-to-Equity Ratio — If a company has $50 in debt and $100 in shareholder equity, D/E is 0.5. Higher means more leveraged — good in boom times, dangerous in downturns.
- Interest Coverage — If you earn $5,000/month and your loan payments are $500, your interest coverage is 10x. Higher is safer — it means the company easily affords its debt payments. A company earning just $600 against that same $500 bill has a coverage of only 1.2x and very little room for a bad month.