Cost of Debt: How to Calculate It and Why It Matters

What Is the Cost of Debt?

The cost of debt is the effective interest rate a company pays on all its debt obligations — loans, bonds, overdrafts, and other interest-bearing borrowings. Unlike the cost of equity, the cost of debt is observable — it is roughly the weighted average interest rate across all debt facilities. The cost of debt is always quoted on an after-tax basis in corporate finance because interest payments are tax-deductible.

The Tax Shield

Interest payments reduce taxable profit, creating a tax benefit known as the tax shield. After-tax cost of debt = Pre-tax cost of debt x (1 - Tax rate). A company borrowing at 6% with a 25% corporation tax rate has an after-tax cost of debt of 6% x (1 - 0.25) = 4.5%. This is why debt financing is often cheaper than equity financing — the government effectively subsidises part of the interest cost through the tax deduction.

How to Calculate Cost of Debt

For simple bank debt: take the interest rate on each facility, weight by the outstanding balance, and apply the tax adjustment. For bonds: use the yield to maturity (YTM) rather than the coupon rate, since YTM reflects the actual market cost of the debt. Pre-tax cost of debt = Total Interest Expense / Average Total Debt. After-tax cost of debt = Pre-tax cost x (1 - Effective Tax Rate).

Cost of Debt in WACC

Cost of debt feeds into WACC alongside the cost of equity. WACC = (E/V) x Ke + (D/V) x Kd x (1-T). A company with a lower cost of debt — achieved through strong credit ratings, asset-backed security, or operating in a low-interest environment — will have a lower WACC, making more investments appear value-creating at a given level of risk. Cost of debt is examined in ACCA AFM and CIMA F3.