The cost of debt refers to how much money it costs a firm when using debt for financing. Whenever anyone takes out debt, they must repay interest on the debt. The interest rate associated with the debt then is the cost of debt, because the interest rate on the debt is how much money the firm must pay to obtain the debt.
Cost of debt is used primarily in weighted average cost of capital equations. For example, Firm A wants to start a construction project. In order to finance the construction project, Firm A must take out a $100,000 loan at a 10 percent interest rate. The cost of debt then is 10 percent because to obtain the $100,000, the firm must pay the lender an additional 10 percent. Often, companies measure cost of debt as after-tax cost of debt because interest expenses on debt are tax deductible.
Determine the interest rate a company is paying on its debt and how long the company has to pay the debt. In our example, if the company has two years to pay back the debt, then the interest rate is 10 percent and the term is two years.
Determine the effective annual interest rate by dividing the interest rate by the term, and adding one. Then, raise the sum to the power of the term. Finally, subtract one. In our example, 10 percent divided by 2 equals 0.05 and 0.5 plus 1 equals 1.5. Then, 1.5 ^ 2 equals 1.1025. Finally, 1.1025 minus 1 equals 10.25 percent. Therefore, 10.25 percent is the effective annual interest rate.
Multiply the effective annual interest rate by one minus the tax rate to determine after-tax cost of debt. In our example, Firm A's tax rate is 35 percent, so one minus the tax rate equals 65 percent. Then, 10.25 percent times 65 percent equals 6.66 percent.