What Is the Cost of Debt?
The cost of debt is the return lenders require to provide financing to a company, expressed as an interest rate. It reflects the risk that the borrower fails to repay: safer companies with strong cash flows and high credit ratings borrow cheaply, while riskier companies pay more.
For valuation purposes, the relevant figure is the current market rate the company would pay to issue new debt, not the historical coupon on old bonds. Analysts often estimate it from the yield to maturity on the company's outstanding bonds or from rates on comparable credits.
How It Works
Because interest expense is deductible for tax purposes, the true economic cost of debt is lower than the stated rate. The after-tax cost of debt equals Rd x (1 - Tc), where Rd is the pre-tax rate and Tc is the tax rate. This tax shield is a key reason companies use leverage at all.
The cost of debt is almost always lower than the cost of equity because lenders have a contractual claim to interest and principal and stand ahead of shareholders in bankruptcy. As a company adds more debt, however, default risk rises and lenders demand higher rates.
Example
Suppose a company's bonds trade at a yield of 6% and its tax rate is 25%. The after-tax cost of debt is 6% x (1 - 0.25) = 4.5%. If debt makes up 30% of the company's capital structure, debt contributes 0.30 x 4.5% = 1.35 percentage points to WACC, with the cost of equity supplying the rest.
Why It Matters
The cost of debt is one of the two building blocks of WACC, so it directly affects DCF valuations and investment hurdle rates. It also shapes real financing decisions, such as whether to fund an acquisition with bonds, bank loans, or equity, and how much leverage an LBO can support.
In interviews, expect questions like "how do you calculate the cost of debt?" and "why do we use the after-tax cost of debt in WACC?" — the answers hinge on current market yields and the interest tax shield.
