Cost of Debt

Cost of debt is the effective interest rate that a company pays on its borrowed capital. It includes interest and other costs of loans and bonds. In valuation, it is one component of the overall cost of capital. It consists of a base rate reflecting general interest levels and a margin compensating the borrower's default risk. Commitment fees, one-off arrangement fees and the cost of providing security raise the effective rate above the nominal coupon.

What matters for valuation is the after-tax view. Where interest is fully tax deductible, the relevant rate equals the cost of debt multiplied by one minus the corporate tax rate. Deductibility restrictions or insufficient taxable profits can limit the tax benefit actually available. There are two routes to deriving the rate: looking at the terms the company has actually agreed and, where these are missing or not at market, deriving it through a synthetic rating that translates metrics such as interest cover and leverage into a risk premium. Importantly, cost of capital should reflect the rate currently obtainable for the target capital structure rather than a historical one, because cost of capital reflects investors’ current required returns.

As leverage rises, the cost of debt may rise with it, which limits the apparent advantage of cheap borrowing. The distinction between the contractual rate of individual tranches and the weighted average across the whole financing also matters, because a structure combining cheap senior with expensive junior capital sits well above the rate of the cheapest tranche. Costs not reflected in the interest rate must also be considered, such as commitment fees on undrawn lines and ongoing security agent fees. For valuation the effective rate derived in this way governs, not the agreed margin.

Note: This explanation is for general information only and does not constitute tax advice. Tax treatment depends on the individual case and may change with new legislation. For a binding assessment, please consult a qualified tax adviser.