Cost of Debt

The cost of debt is the effective interest rate a company pays on borrowed funds (loans, bonds, etc.). It reflects lenders’ required return for lending and helps assess a firm’s risk profile and financing mix. Interest expense is generally tax-deductible, so analysts distinguish between the before-tax and after-tax cost of debt.

How it works

• Debt is a core part of a company’s capital structure (debt + equity).
• Lenders price debt based on the risk-free rate plus a credit spread that compensates for credit risk and other factors.
• A higher perceived borrower risk leads to a larger credit spread and a higher cost of debt.
• Cost of debt is typically lower than cost of equity because debt holders have priority claims and interest is tax-deductible.

Key formulas

After-tax cost of debt:
ATCD = (Risk-free rate + Credit spread) × (1 − Tax rate)

Where:
– Risk-free rate = yield on a risk-free instrument (e.g., U.S. Treasuries)
– Credit spread = additional yield over the risk-free rate due to borrower credit risk
– Tax rate = company’s effective tax rate (used to reflect the tax deductibility of interest)

Before-tax (average) cost of debt (weighted average interest rate):
Total annual interest paid ÷ Total outstanding debt

Examples

1) Using risk-free rate and credit spread:
– Risk-free rate = 1.5%; credit spread = 3% → pretax cost = 4.5%
– If tax rate = 30%: after-tax cost = 4.5% × (1 − 0.30) = 3.15%

2) Using weighted average of individual loans:
– $1,000,000 at 5% and $200,000 at 6%:
– Total interest = $50,000 + $12,000 = $62,000
– Total debt = $1,200,000 → pretax cost = $62,000 / $1,200,000 = 5.17%
– If tax rate = 30%: after-tax cost = 5.17% × 0.70 ≈ 3.62%

3) Small-business example:
– $250,000 at 5% and $150,000 at 4.5%:
– Annual interest = $12,500 + $6,750 = $19,250
– Total debt = $400,000 → pretax cost = $19,250 / $400,000 = 4.81%

Impact of taxes

Because interest is generally tax-deductible, the after-tax cost of debt is lower than the pretax cost. The tax benefit equals the interest expense multiplied by the company’s tax rate, which reduces the effective cost. The referenced approach uses the company’s effective tax rate (combining state and federal rates) when calculating after-tax cost.

What increases the cost of debt?

• Higher borrower risk or weaker credit rating → larger credit spread
• Longer maturities (greater time value of money and uncertainty)
• Unsecured debt (no collateral) → higher rates than secured loans
• Deteriorating financial metrics or increased default risk

How to reduce cost of debt

• Negotiate better terms with lenders
• Refinance when market rates fall or credit profile improves
• Make larger or more frequent payments to reduce principal faster
• Improve creditworthiness (timely payments, reduce leverage, correct credit report errors)

Cost of debt vs. cost of equity

• Debt typically costs less than equity because of lower risk to lenders and tax-deductible interest.
• Equity does not provide tax shields and usually requires higher expected returns.
• Firms balance debt and equity to minimize their weighted average cost of capital (WACC) while managing default risk.

Agency cost of debt

Debtholders may impose covenants to limit management actions that favor shareholders at debt holders’ expense. These covenants protect lenders by restricting certain uses of capital or requiring adherence to financial metrics; violation can trigger default or accelerated repayment.

Key takeaways

• Cost of debt measures the effective interest rate a company pays on its borrowings.
• Calculate it either as a weighted average of interest rates (pretax) or using risk-free rate + credit spread, adjusted for taxes.
• After-tax cost of debt = pretax cost × (1 − tax rate), reflecting the tax deductibility of interest.
• Firms can lower cost of debt by improving creditworthiness, negotiating, refinancing, or paying down principal.