Cost of Debt

The cost of debt is the interest rate a company pays on its borrowed funds. Unlike cost of equity, which must be estimated using models like the capital asset pricing model, cost of debt is often directly observable from bond yields or loan rates. Its key peculiarity is that interest is tax-deductible, creating a tax shield that lowers the true cost to the company.

What cost of debt is

When a company borrows money, it promises to pay interest. A company that issues bonds yielding 5% has a cost of debt of 5%. A company with a bank loan at a floating rate of LIBOR plus 2% has a cost of debt of LIBOR plus 2%.

Cost of debt is risk-adjusted: a company with poor credit (junk bonds) pays more (8%, 10%, even 15%) than a company with excellent credit (2–3%). The difference reflects the risk of default.

Where to find cost of debt

For public companies with traded bonds. Look at the yield-to-maturity on outstanding debt. If a bond trades at $950 with a 5% coupon and matures in 5 years, the YTM is roughly 5.5%. This is the company’s cost of debt.

For companies with bank loans. The interest rate on the loan agreement is the cost of debt.

For non-public companies. Estimate using credit rating and comparable-company yields. A company with a BBB credit rating might pay 4–5% in normal times. A company with a CCC rating might pay 10%+.

For a diversified debt portfolio. Weight the cost of each debt instrument by its amount and average. A company with 100 million of 4% bonds and 50 million of 6% bank debt has a blended cost of 4.67%.

The tax shield: after-tax cost of debt

Here is the key difference from cost of equity: interest is tax-deductible. If a company has a 5% cost of debt and a 25% tax rate, the after-tax cost is 5% times (1 minus 0.25), or 3.75%.

Why? Because the company saves 1.25% in taxes (25% of 5%) by paying interest instead of equity returns. This tax shield is real and valuable. It is why companies use debt—not just because it is cheaper, but because it is cheaper on an after-tax basis.

In the weighted average cost of capital formula, you always use the after-tax cost of debt:

WACC = (E / D+E) × Cost of Equity + (D / D+E) × After-tax Cost of Debt

Where D is market value of debt and E is market value of equity.

Marginal vs. average cost of debt

Average cost of debt. What the company currently pays on all its debt, blending different rates and terms. This is what you observe from financial statements.

Marginal cost of debt. What the company would have to pay on new borrowing. If a company has weathered hard times but is now recovering, its marginal cost of debt (fresh borrowing) might be lower than its average cost (old, expensive debt).

For valuation, use marginal cost of debt if you are forecasting new borrowing. Use average cost if you are assessing the current state.

Estimating credit spreads

For a company without traded bonds, you can estimate cost of debt from credit spreads:

1. Identify the company’s credit rating (or estimate it from financial ratios like interest coverage or debt-to-EBITDA).

2. Look up the yield spread for that rating over Treasuries. A BBB rated company might trade at +200 basis points (2%) over Treasuries.

3. Add the spread to the risk-free rate. If Treasuries yield 4% and the spread is 2%, the cost of debt is 6%.

Spreads vary with economic conditions. In boom times, spreads compress (lower costs). In recessions, they widen (higher costs).

Leverage and cost of debt

Unlike cost of equity, cost of debt is typically less sensitive to the company’s leverage. Whether a company has 30% debt or 60% debt, its cost of debt might be similar. Once leverage exceeds 70–80%, debt costs can rise sharply due to default risk.

But over-leveraged companies face increasing debt costs as leverage rises. A company with debt-to-value of 80%+ might be unable to borrow at any reasonable rate.

Permanent vs. temporary debt

In perpetuity-based valuation models, you assume a stable capital structure. This means debt-to-value ratios are constant in perpetuity, and thus cost of debt is constant.

If you forecast debt declining significantly (e.g., a leveraged buyout with an explicit debt paydown schedule), the cost of debt in early years might be high (reflecting current high leverage), then decline as leverage normalizes.

Currency considerations

For companies with multi-currency debt, you might need to weight by currency. A company with 100 million in US dollars and 50 million in euros has different costs in each currency. Calculate a blended rate or, in some cases, use a single home-currency rate if the company hedges.

Common pitfalls

Using the coupon rate instead of yield-to-maturity. A bond might have a 4% coupon but trade at a discount, yielding 5% to maturity. Use YTM, not coupon.

Ignoring flotation costs. When a company issues new debt, it pays fees to banks and underwriters. These are small (1–3%) but add to the cost.

Using pre-tax instead of after-tax cost. WACC always uses after-tax cost of debt. This is non-negotiable.

Assuming constant cost of debt under changing leverage. If you forecast debt tripling, the cost of debt likely rises. Adjust accordingly.

See also