Cost of Debt
Definition
The cost of debt is the return lenders require — in practice, the yield the company would pay to borrow today. It is estimated from the yield to maturity on the company's existing traded bonds, yields on similarly rated companies' debt, or the risk-free rate plus a credit spread appropriate for the rating; the coupon on old debt is only a rough proxy since rates change.
In WACC, the cost of debt enters after tax — cost of debt x (1 − tax rate) — because interest expense is tax-deductible, reducing the effective cost of borrowing (subject to deductibility limits in some jurisdictions).
The cost of debt rises with leverage and credit risk. For most companies it is well below the cost of equity because debt has a senior, contractual claim.
Why interviewers ask
Interviewers ask how you would estimate the cost of debt for a company with no traded bonds (comparable ratings/spreads) and why it is tax-adjusted in WACC but the cost of equity is not (dividends are not tax-deductible). The trap is using an old coupon rate rather than the current market yield.
Related terms
Interviews don't test definitions — they test recall under pressure.
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