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What is the Cost of Debt?

Alexis W.
Alexis W.

The cost of debt refers to the effective interest rate a company pays on the debt it borrows. The cost of debt can be written as either before-tax cost or after-tax cost. Most commonly, the cost of debt is reported in after-tax costs, since interest on most debt is deductible on tax returns.

Companies borrow money for a number of reasons. Often, debt is necessary to expand a business or to keep a business running smoothly. All of this debt, however, comes at a cost: the interest rate charged on the money that the company is borrowing, which is the amount of money the company pays for the privilege of using borrowed money to expand.

Man climbing a rope
Man climbing a rope

The money that companies borrow comes from a number of sources, and thus there are many different types of company debt. For example, companies may borrow money by issuing equity in the company, in the forms of stocks and bonds issued to investors. The interest rate on these bonds is the amount paid to the investor who invested in the company; in other words, it is the rate of return that the company has promised to the investor who purchased the bonds.

The total debt a company has is reported as part of the company's capital structure on profit-loss documents and other related financial documents. This item is listed, along with the cost of equity, as part of the company's total capital assets and liabilities. Public companies release this information as part of filings with regulatory agencies, such as the Securities and Exchange Commission in the United States.

Investors can look at the cost of debt when evaluating an investment. Companies that have poorer credit ratings or a less sound financing structure often must pay a higher interest rate, due to the increased chance that the company will default on those debts. Therefore, when an investor is looking at a company and considering whether to invest, he can look at the cost of debt as a measure of risk.

Individual debts that a company has may come at a different cost of debt. For example, a company may issue certain bonds with a six percent interest rate. If the company issued other bonds at a different interest rate or took other loans, those other loans or bonds would have a different cost of debt.

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