Cost of Debt
The effective interest rate a company pays on its borrowed funds, after adjusting for tax savings.
What is Cost of Debt?
The cost of debt is the effective rate of return that a company pays to its debt holders. It is typically expressed as an after-tax figure because interest payments are tax-deductible in most jurisdictions — this tax shield reduces the true cost of debt to the company. The after-tax cost of debt is calculated as: Kd = Rd × (1 − T), where Rd is the pre-tax interest rate and T is the corporate tax rate. For publicly traded companies, the cost of debt can be estimated from the yield to maturity of outstanding bonds. Along with the cost of equity, cost of debt is a key input to WACC.
Example
A company issues bonds at a 7% coupon rate and faces a 25% corporate tax rate. Its after-tax cost of debt is 7% × (1 − 0.25) = 5.25%. This 5.25% is what the debt actually costs the company when the tax benefit is accounted for — compared to a 10%+ cost of equity, this illustrates why debt financing appears cheaper in isolation.