Cost of Debt
Cost of debt is the effective interest rate a company pays on its borrowed funds, adjusted for the corporate tax deductibility of interest, and represents the debt component used in calculating the Weighted Average Cost of Capital.
For a publicly traded US company with outstanding bonds, the cost of debt is most directly observed from the yield to maturity (YTM) on those bonds in the secondary market. If Amazon's 10-year bonds trade at a yield of 5.2%, that is the market's current assessment of the pre-tax cost of that debt. For companies without publicly traded debt, analysts use the interest expense divided by average debt balances from the financial statements as a rough approximation, or reference credit ratings to interpolate a spread over the risk-free rate.
The formula for after-tax cost of debt is: Rd_after-tax = Rd x (1 - Tc), where Rd is the pre-tax yield and Tc is the marginal corporate tax rate. At the current US federal corporate tax rate of 21%, a company paying 5% on its bonds has an after-tax cost of debt of 5% x (1 - 0.21) = 3.95%. State corporate taxes would modestly increase the effective total tax rate.
The tax shield makes debt structurally cheaper than equity on an after-tax basis for most profitable US companies. This is one reason investment-grade companies like AT&T or Verizon have historically carried substantial debt loads: the after-tax cost is manageable, and the interest deductions reduce taxable income significantly. However, companies with net operating loss carryforwards (NOLs) — as commonly seen in early-stage or recently restructured firms — may derive little immediate benefit from the interest deduction, effectively raising their true cost of debt.
Cost of debt can change materially over time. When interest rates rise, as they did dramatically in 2022-2023 when the Federal Reserve raised the federal funds rate from near zero to over 5%, the cost of new debt issuance surged. Companies refinancing maturing debt into a higher-rate environment saw their interest expense jump and their WACC increase, compressing DCF-derived valuations across the market. Conversely, a credit downgrade — as happened to Ford in 2020 when it was cut to high-yield — raises the spread over Treasuries, increasing cost of debt.
Analysts modeling multi-year DCFs should consider whether the current debt maturity schedule will force refinancing at materially different rates, particularly for highly leveraged companies. A roll-forward model that tracks each tranche of debt, its maturity, and the expected refinancing rate provides a more precise interest expense forecast than simply holding the current cost of debt flat throughout the projection period.