COST OF DEBT
Back to GlossaryDefinition
The effective rate a company pays on its borrowings, net of the tax shield from interest deductions.
Summary
Cost of debt is the actual interest rate a company pays on its borrowed money after accounting for tax benefits. Since interest payments are tax-deductible, the true cost of debt is lower than the stated interest rate. For example, if a company borrows at 8% interest and has a 25% tax rate, the after-tax cost of debt is 6% (8% × (1 - 0.25)). This metric is crucial for calculating a company's weighted average cost of capital (WACC) and making financing decisions.
Usage Context
Essential for capital budgeting decisions, WACC calculations, optimal capital structure analysis, and comparing financing alternatives. Critical when evaluating whether to use debt or equity financing for new projects.
Common Confusions
- Using pre-tax interest rates instead of after-tax rates
- Confusing cost of debt with total interest expense
- Not understanding why debt is cheaper than equity financing
- Assuming all debt has the same cost regardless of terms or rating
- Forgetting to weight different debt instruments when calculating overall cost
