Cost of Debt

The Cost of Debt represents the after-tax cost of debt capital to a company. It can be determined in The Cost of Capital Calculator based on the rates you enter for the Yield to Maturity (YTM) and the Marginal Tax Rate.

It is important that the rate you enter is the current yield to maturity rather than the nominal cost of debt. The nominal or coupon rate (which is based on the face amount of the debt) determines the interest payment, but it does not necessarily reflect the actual cost of the corporation's debt today. As required returns change (because of changing expectations about future inflation levels and economic conditions), the price of a debt issue changes so that the actual interest payments (the nominal rate multiplied by the face amount) and anticipated proceeds at maturity yield the investors their revised required return. The yield to maturity, not the nominal rate, fully reflects the current return demanded by debtholders and the rate at which debt should be replaced.

In estimating the Cost of Debt (yield to maturity), be sure to use a long-term rate. Short-term interest rates do not incorporate long-term expectations about inflation. In projecting financial data for 5 to 10 years into the future, you should use a cost of capital that is consistent with the long-term time horizon of the forecast. Also, even if a company routinely “rolls over” short-term debt as permanent financing, the long-term rate is still a better approximation of the future Cost of Debt because interest rates on long-term debt incorporate the expected cost of repeated short-term borrowing.

The Cost of Debt represents the future cost of debt over a long period. Use the yield to maturity on long-term debt.