Financial Glossary
Cost of Debt
Cost of debt is the effective rate a company pays on its borrowed capital, expressed as an annual percentage. The pre-tax cost of debt is the weighted average interest rate across all outstanding loans, bonds, and credit facilities. Because interest expense is typically tax-deductible, the after-tax cost of debt is: Pre-tax Cost of Debt times (1 minus Effective Tax Rate). After-tax cost of debt is the number used in weighted average cost of capital (WACC) calculations to blend debt and equity costs. Companies with strong credit ratings and collateral access lower-cost debt; startups or riskier borrowers pay higher rates reflecting the lender's assessed default risk.
Problem & Application
A campground operator carries three debt instruments: a $1,000,000 mortgage at 6.5%; a $200,000 SBA equipment loan at 7.0%; and a $100,000 line of credit at 8.5%. Weighted average pre-tax cost of debt = [(1,000,000 times 6.5%) + (200,000 times 7.0%) + (100,000 times 8.5%)] divided by $1,300,000 = [$65,000 + $14,000 + $8,500] divided by $1,300,000 = 6.73%. At a 25% effective tax rate, after-tax cost of debt = 6.73% times (1 - 0.25) = 5.05%. This figure feeds into the WACC calculation used for project discount rates and acquisition underwriting. Reducing the cost of debt through refinancing or paying down the higher-rate line of credit directly lowers the hurdle rate for capital projects.
In Short
Managing cost of debt is crucial for sustainable financing. Companies should balance debt with equity financing and seek favorable interest rates to optimize capital structure.