Cost of debt

What it means

The cost of debt is the price a company pays for borrowed money: bank loans, bonds, leases or shareholder loans. It consists mainly of interest, but also arrangement and management fees, commitment fees and the cost of providing security.

Because interest is usually tax-deductible, it reduces income tax. The real cost of debt is therefore lower than the nominal interest rate. After tax it is calculated as the interest rate multiplied by one minus the income tax rate.

This cost feeds into the weighted average cost of capital, WACC, together with the cost of equity. Debt is usually cheaper than equity because lenders rank ahead in repayment and carry less risk than owners.

How it works in practice

The nominal interest rate is not enough to compare loan offers. All fees must be included and the effective interest rate calculated. A loan with a lower rate and a high arrangement fee can be more expensive than one with a higher rate and no fees.

In investment decisions, the cost of debt forms part of the discount rate. If a company has loans at different rates, a weighted average by amount is used. When planning new financing, current market rates are relevant rather than historical ones.

The mix of debt and equity, the capital structure, affects the overall cost of funding. Moderate borrowing can lower WACC thanks to the tax saving, but with high leverage risk rises, banks demand higher rates and the advantage disappears.

What to watch out for

The tax saving on interest is not unlimited. For loans from related parties, thin capitalisation rules limit interest deductibility by reference to EBITDA, and interest must reflect market terms. The tax effect must therefore be assessed realistically in the calculation.

If a company is loss-making, the tax saving on interest does not materialise immediately, and the real cost of debt is closer to the nominal rate. For loss-making or start-up companies, the simplified after-tax calculation is therefore misleading.