Cost of Debt

When a company borrows, lenders charge interest to compensate for the time value of money and the risk of not being repaid. The cost of debt is the overall rate the company pays on its borrowing.

For a company with a single loan at 6%, the cost of debt is simply 6%. For a company with several loans and bonds, it is a weighted average of their rates. Analysts often use the current yield on the company's bonds, or the rate it would pay on new borrowing, because that reflects today's market conditions better than old loan rates.

The cost of debt depends mainly on the company's credit risk and on general interest rates. A financially strong company with a high credit rating borrows more cheaply than a weaker one. When central banks raise rates, borrowing costs for all companies tend to rise.

Debt is usually cheaper than equity, because lenders are paid before shareholders and take less risk. In many tax systems, interest is also deductible from taxable profit, which lowers the effective cost further. That adjusted figure is called the after-tax cost of debt.