What Does Cost of Debt Mean?
The cost of debt is the cost or the effective rate that a firm incurs on its current debt. Debt forms a part of a firm’s capital structure. Since debt is a deductible expense, the cost of debt is most often calculated as an after-tax cost to make it more comparable to the cost of equity.
Divestopedia Explains Cost of Debt
Debt is one part of a firm’s capital structure. A firm uses various bonds, loans and other forms of debt, so cost of debt is the rate paid by the firm to use this debt as a means of finance. Multiplying the before-tax rate (by one, minus the marginal tax rate) gives the after-tax rate. This measure gives the investors an idea of the riskiness of the firm compared to others in the industry. A firm with a higher risk profile will have a higher cost of debt, so the cost of borrowing decreases as debts become safer.
In simple terms, the cost of borrowing can be taken as the rate of interest paid on debts. However, interest itself is a function of the riskiness of an investment. If the risk-free rate is the rate of return on a risk free bond of a similar term (Rf), then adding a risk premium that takes into consideration the probable risk of default determines the company-specific rate of interest. The default premium increases as the amount of debt increases and the credit worthiness of the firm decreases. The formula to determine the cost of debt is as follows:
Cost of Debt = ( Rf + credit risk rate) (1- tax rate)