Cost of Debt

The cost of debt, in a valuation context, is the expected interest rate that a company pays on its debt obligations. Because interest is deductible, it is the after-tax cost of debt that is the relevant measure. In practice, the rate used is typically the marginal rate promised on a company’s debt obligations.

A firm may use various kinds of debt including loans and bonds. Each of these will have contractual conditions. For instance, a bank loan may require that certain financial performance ratios be maintained. Bonds may be subordinated to other obligations or may have a floating rate.

It is important to distinguish between the cost of debt and the market yield on the debt. The yield of a debt instrument is the promised rate of return on that instrument at current market values, that is, the return that its holder will realize if the issuer does not default. In contrast, the expected rate of return on a debt instrument is the average return across all outcomes, including default and partial repayment. The latter is, in principle, the relevant measure of the cost of debt that should be included in the calculation of the WACC, though in practice the difference often is ignored when small. See Valuation > Income Approach > DCF Method > Discount Rate.

Another important difference is between the market yield and the stated interest rate or coupon rate on a debt instrument. The latter is sometimes called the embedded cost of debt. Bonds and loans have a face value (sometimes called par value), which is the principal amount that the borrower has to repay at maturity. Coupon rates (for bonds) and stated interest rates (for loans) are defined with respect to this face value, meaning interest payments are calculated by multiplying the face value by the coupon or interest rate. Over time, however, the price of a debt instrument varies as market interest rates or the credit quality of the borrower change, and the bond or loan price can be higher or lower than its face value. The yield is the implied interest rate that a buyer of the bond at its market price expects as of a particular date, provided the borrower does not default. The yield and the coupon or stated rate are equal only if the price is equal to the face (or par) value.

For purposes of calculating the cost of debt in a WACC calculation, the market yield is the relevant cost of debt because it reflects a forward-looking cost of debt. The historical interest rate or coupon on a company’s existing debt, called the embedded cost of debt, reflects conditions that existed at the date the debt was originally incurred and may no longer be relevant as of the valuation date.