What is Cost of Debt?

Cost of debt (Kd) is the effective rate a company pays on its total debt obligations. Because interest expense is tax-deductible, the after-tax cost of debt is used in [WACC](https://www.ibflash.com/concepts/wacc) calculations. It is almost always lower than the [cost of equity](https://www.ibflash.com/concepts/cost-of-equity), which is why companies use leverage to lower their overall cost of capital — up to a point. This dynamic is central to [capital structure](https://www.ibflash.com/concepts/capital-structure) decisions.

Cost of Debt

Cost of debt is what a company pays to borrow money, reduced by the tax benefit of deducting interest. It's the cheapest source of capital because lenders get paid first.

Definition

Cost of debt (Kd) is the effective rate a company pays on its total debt obligations. Because interest expense is tax-deductible, the after-tax cost of debt is used in WACC calculations. It is almost always lower than the cost of equity, which is why companies use leverage to lower their overall cost of capital — up to a point. This dynamic is central to capital structure decisions.

Formula

After-tax Cost of Debt = Yield to Maturity × (1 - Tax Rate)

→

Yield to Maturity (YTM)

The market interest rate on the company's debt — use current yields, not coupon rates

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Tax Rate

Marginal corporate tax rate — interest is tax-deductible, creating a tax shield

WACC Formula Breakdown

WACC = (E/V x Re) + (D/V x Rd x (1-T))

Equity (E)

$800M

Debt (D)

$200M

Total (V)

$1B

10%

Tax Rate

25%

Equity Weight (E/V)$800M / $1B

80%

Cost of Equity (Re)Required return for shareholders

10.0%

Equity Contribution80% x 10.0%

8.0%

Debt Weight (D/V)$200M / $1B

20%

After-Tax Cost of Debt5.0% x (1 - 25%)

3.75%

Debt Contribution20% x 3.75%

0.75%

equals

WACC8.75%

8.0% + 0.75% = 8.75%

Capital Structure Weighting

How each source contributes to total WACC

8.75%WACC

Equity — 80% of capital

Cost of equity: 10% | Weight: 80%

8.0%

Debt — 20% of capital

After-tax cost: 3.75% | Weight: 20%

0.75%

Pre-tax vs. After-tax Cost of Debt

The pre-tax cost of debt is the yield investors require to hold the company's debt. The after-tax cost reflects the tax shield from deducting interest expense. For example, if a company borrows at 6% and its tax rate is 25%, the after-tax cost is 6% × (1 - 0.25) = 4.5%. WACC always uses the after-tax cost of debt because the tax shield is a real economic benefit.

How to Determine the Pre-tax Cost

For public companies with traded bonds, use the yield to maturity on existing bonds. For companies without traded debt, use the synthetic rating approach: estimate the credit rating based on financial metrics (Debt/EBITDA, interest coverage), then look up the corresponding bond yield spread over treasuries. You can also use the weighted average interest rate from financial statements as a rough proxy.

Cost of Debt in WACC

In WACC, the after-tax cost of debt is weighted by the company's debt as a percentage of total capitalization (at market values). Because debt is senior to equity and has a tax benefit, Kd is almost always lower than Ke. However, too much debt increases financial risk, which raises both Kd and Ke — there is an optimal capital structure that minimizes WACC.

Worked Example — With Real Numbers

A company has $500M of bonds trading at a yield to maturity of 5.5%. The marginal tax rate is 25%. After-tax Kd = 5.5% × (1 - 0.25) = 4.125%. If the company's [capital structure](https://www.ibflash.com/concepts/capital-structure) is 40% debt and 60% equity, the debt component of WACC = 4.125% × 40% = 1.65%.

Key Takeaways

Always use after-tax cost of debt in WACC — the tax shield is a real benefit

Use yield to maturity on existing debt, not the coupon rate, for current market cost

Cost of debt is the cheapest capital source because lenders have priority and interest is tax-deductible

Excessive leverage raises Kd as credit risk increases

Common Mistakes in Interviews

Using the coupon rate instead of yield to maturity — the coupon is the historical rate, not the current market rate

Forgetting to tax-affect the cost of debt in WACC

Using the book value of debt instead of market value for WACC weights

How Interviewers Test This

If asked 'how do you find the cost of debt for a private company?', explain the synthetic rating approach: estimate credit metrics, map to a rating, and add the corresponding spread to the risk-free rate. Try the DCF Calculator to see how cost of debt feeds into WACC.

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