Cost of Debt
The cost of debt is the effective interest rate that a company pays on its borrowings, representing the minimum return that debt providers require to lend to the company and serving as the key input to the debt component of the Weighted Average Cost of Capital (WACC) calculation. Because interest payments are tax-deductible, the after-tax cost of debt is lower than the pre-tax rate.
Key takeaways
- After-tax cost of debt = Pre-tax cost of debt × (1 − Tax Rate) — the tax shield on interest reduces the effective cost of debt financing.
- The marginal cost of debt (rate on newly issued debt) is more relevant for investment decisions than the historical average cost of existing debt.
- For investment-grade companies, cost of debt ≈ Risk-free rate + Credit spread (derived from credit rating or current market spreads).
- Rising interest rates or credit downgrades increase the cost of debt, raising WACC and reducing the present value of future cash flows in a DCF model.
- Debt instruments with embedded features (convertibility, PIK toggle, floating rates) require adjustments to compute the true economic cost of debt.
Explanation
The cost of debt is one of two components of the Weighted Average Cost of Capital, alongside the cost of equity. It represents the current yield that a company's creditors require on its outstanding and newly issued debt obligations. For publicly rated companies with bonds trading in secondary markets, the cost of debt is most accurately estimated from the yield-to-maturity (YTM) of the company's outstanding bonds — specifically, the YTM of liquid, non-callable, non-puttable bonds closest to par and with the most representative maturity.
Alternatively, for investment-grade companies without publicly traded bonds, cost of debt can be estimated by looking up the credit spread associated with the company's S&P or Moody's credit rating and adding it to the comparable-maturity Treasury yield. High-yield issuers may need to use the yield on comparable CDS contracts or comparable-maturity bonds from similarly rated issuers.
The after-tax cost of debt is what enters the WACC formula:
After-Tax Cost of Debt = r_d × (1 − t)
where r_d is the pre-tax cost of debt and t is the marginal corporate tax rate. This adjustment reflects the interest tax shield — interest payments reduce taxable income, meaning the government effectively subsidizes corporate borrowing. At a 21% U.S. corporate tax rate, a company paying 6% on its bonds has an after-tax cost of debt of 6% × (1 − 0.21) = 4.74%.
For leveraged buyout (LBO) analysis, where a company's capital structure is predominantly debt, the cost of debt is the primary driver of equity returns. An LBO financed at 8% on term loans versus 6% makes a substantial difference to the equity IRR over a 5-year hold period. Similarly, in distressed company analysis, the cost of debt may approach 20–30% for CCC-rated or defaulted issuers, reflecting the market's expectation that the debt will not be fully repaid — making WACC analysis less relevant and recovery value analysis more central.
Formula
After-Tax Cost of Debt = r_d × (1 − Tax Rate) | WACC = r_e × (E/V) + r_d × (1 − t) × (D/V)
Example
Amazon has $67 billion in long-term debt. Its most liquid outstanding bonds — 10-year investment-grade notes — trade at a yield to maturity of 5.1%. Amazon's marginal corporate tax rate is approximately 21%. After-tax cost of debt = 5.1% × (1 − 0.21) = 4.03%. In a WACC calculation: Amazon's equity market cap is $1.8 trillion, debt is $67 billion, total capital $1.867 trillion. Debt weight = $67B / $1,867B = 3.6%. Cost of equity (CAPM) = 4.3% + 1.1 × 5.5% = 10.35%. WACC = 10.35% × 96.4% + 4.03% × 3.6% = 9.98% + 0.15% = 10.13%. The low weight of debt in Amazon's capital structure means the cost of debt has minimal impact on WACC, unlike highly leveraged companies where cost of debt dominates.
Related terms
Accounts Receivable Turnover Accrual Accounting Cap Capital Structure Cost Of Equity Credit Rating Credit Spread Current Ratio Current Yield Equity Interest Coverage Ratio Interest Rate