{"concept":{"id":74,"slug":"cost-of-debt","term":"Cost of debt","shortDefinition":"The effective interest rate a company pays on its financial debt, adjusted for the tax benefit of interest.","longDefinition":"Cost of debt is the effective interest rate a company pays on its financial debt -- the same financial debt, already distinguished from total liabilities, that's part of invested capital, already covered in Level 2. It isn't simply the nominal interest rate: because interest on debt is tax-deductible, the real cost the company bears is lower than the rate it pays -- the so-called \"tax shield\" of debt. That's why the cost of debt relevant to the WACC is the after-tax cost: the interest rate multiplied by (1 minus the tax rate). It's generally lower than the cost of equity, because debt is less risky for whoever provides it -- it has priority of repayment over shareholders if the company runs into trouble."},"relations":{"requirement":[],"contrast":[],"related":[{"concept":{"id":59,"slug":"invested-capital","term":"Invested capital","shortDefinition":"Financial debt plus equity -- all the capital financing a company's business, regardless of whether it comes from third parties or its shareholders.","longDefinition":"Invested capital is the sum of a company's financial debt and equity -- all the capital financing its business, wherever it comes from. It's important to distinguish financial debt from total liabilities, the same nuance already covered when calculating the debt-to-equity ratio: total liabilities include non-financial items, like what's owed to suppliers, which aren't part of invested capital because they carry no explicit financial cost. Invested capital is ROIC's denominator, and its precise definition matters as much as ROIC's own -- confusing financial debt with total liabilities inflates invested capital and distorts the calculated ROIC."}}],"calculatedBy":[{"concept":{"id":76,"slug":"wacc","term":"WACC","shortDefinition":"The precise calculation of the cost of capital: the weighted average of the cost of debt and the cost of equity, according to each one's weight in the company's financing.","longDefinition":"WACC (Weighted Average Cost of Capital) is the precise specialization of the cost of capital, already covered in general terms in Level 2 and used that way by ROIC and DCF. WACC combines the after-tax cost of debt and the cost of equity, each weighted by its relative share in the company's total financing: the greater the proportion of debt versus equity, the more the average leans toward debt's cost -- generally lower -- and vice versa. The result is a single discount rate, but not an exact, unquestionable figure: it depends directly on the estimates of its two components -- particularly the cost of equity, sensitive to CAPM's assumptions -- and on the financing weights used. It's the figure ROIC compares against business returns, and that DCF uses to discount its future flows, now calculated precisely instead of estimated in general terms."}}]},"curricularPosition":[{"id":61,"moduleId":22,"slug":"what-is-the-cost-of-debt","title":"What is the cost of debt?","summary":"You know what a company's cost of debt is and why the cost that really matters is the after-tax cost.","bodyMarkdown":"## Objectives\n\nBy the end of this lesson you know what a company's cost of debt is and why the cost that really matters is the after-tax cost.\n\n## Content\n\nROIC and DCF, already covered in earlier modules, used cost of capital as a general figure -- the minimum return a company should generate to justify the capital it has invested. This module starts pinning down that figure, component by component. The first is cost of debt.\n\nCost of debt is the effective interest rate a company pays on its financial debt -- the same financial debt that, already covered when calculating invested capital in Level 2, is distinguished from total liabilities: it doesn't include what's owed to suppliers or other items with no explicit financial cost, only debt that actually generates interest.\n\nBut the interest rate the company pays isn't, on its own, the real cost it bears. Interest on debt is tax-deductible: it reduces the income taxes are calculated on, so part of that interest is indirectly \"paid\" by the tax authorities, not the company. This is called the tax shield of debt. The cost of debt that really matters for valuing a company is the after-tax cost: the interest rate the company pays, multiplied by one minus its applicable tax rate.\n\nFor this reason -- and because lenders have priority of repayment over shareholders if the company runs into trouble, which makes debt less risky for whoever provides it -- the cost of debt is generally lower than the cost of equity, covered in the next lesson.\n\n## Example\n\nA company pays 5% annual interest on its financial debt. If its applicable tax rate is 25%, the after-tax cost of debt is 5% × (1 − 0.25) = 3.75% -- more than a percentage point below the nominal interest rate, precisely because of the tax shield.\n\n## Common mistakes\n\n- Using the nominal interest rate on debt without adjusting for the tax shield, which overstates the real cost the company bears.\n- Calculating the cost of debt on total liabilities instead of financial debt, confusing items with no explicit financial cost (like what's owed to suppliers) with real debt.\n\n## Summary\n\nCost of debt is the effective interest rate a company pays on its financial debt, adjusted for the tax shield on interest -- the after-tax cost, not the nominal rate. It's usually lower than the cost of equity because debt is less risky for whoever provides it.\n\n## Self-check\n\nWhy is the relevant cost of debt the after-tax cost and not the nominal interest rate?\n\nWhy is the cost of debt calculated on financial debt and not on total liabilities?","bodyHtml":"<h2>Objectives</h2>\n<p>By the end of this lesson you know what a company's cost of debt is and why the cost that really matters is the after-tax cost.</p>\n<h2>Content</h2>\n<p>ROIC and DCF, already covered in earlier modules, used cost of capital as a general figure -- the minimum return a company should generate to justify the capital it has invested. This module starts pinning down that figure, component by component. The first is cost of debt.</p>\n<p>Cost of debt is the effective interest rate a company pays on its financial debt -- the same financial debt that, already covered when calculating invested capital in Level 2, is distinguished from total liabilities: it doesn't include what's owed to suppliers or other items with no explicit financial cost, only debt that actually generates interest.</p>\n<p>But the interest rate the company pays isn't, on its own, the real cost it bears. Interest on debt is tax-deductible: it reduces the income taxes are calculated on, so part of that interest is indirectly &quot;paid&quot; by the tax authorities, not the company. This is called the tax shield of debt. The cost of debt that really matters for valuing a company is the after-tax cost: the interest rate the company pays, multiplied by one minus its applicable tax rate.</p>\n<p>For this reason -- and because lenders have priority of repayment over shareholders if the company runs into trouble, which makes debt less risky for whoever provides it -- the cost of debt is generally lower than the cost of equity, covered in the next lesson.</p>\n<h2>Example</h2>\n<p>A company pays 5% annual interest on its financial debt. If its applicable tax rate is 25%, the after-tax cost of debt is 5% × (1 − 0.25) = 3.75% -- more than a percentage point below the nominal interest rate, precisely because of the tax shield.</p>\n<h2>Common mistakes</h2>\n<ul><li>Using the nominal interest rate on debt without adjusting for the tax shield, which overstates the real cost the company bears.</li><li>Calculating the cost of debt on total liabilities instead of financial debt, confusing items with no explicit financial cost (like what's owed to suppliers) with real debt.</li></ul>\n<h2>Summary</h2>\n<p>Cost of debt is the effective interest rate a company pays on its financial debt, adjusted for the tax shield on interest -- the after-tax cost, not the nominal rate. It's usually lower than the cost of equity because debt is less risky for whoever provides it.</p>\n<h2>Self-check</h2>\n<p>Why is the relevant cost of debt the after-tax cost and not the nominal interest rate?</p>\n<p>Why is the cost of debt calculated on financial debt and not on total liabilities?</p>","sortOrder":1,"readingMinutes":7,"difficulty":"Intermedio","url":"/en/academy/valuation/wacc-and-cost-of-capital/what-is-the-cost-of-debt"}],"graphSummary":{"root":{"type":"concept","id":"74","depthFromRoot":0,"entity":{"type":"concept","slug":"coste-de-la-deuda","term":"Coste de la deuda","excerpt":"Tipo de interés efectivo que paga una empresa por su deuda financiera, ajustado por el beneficio fiscal de los intereses."}},"depth":1,"returnedNodes":1,"truncated":false,"hasCycle":false,"nodes":[{"type":"concept","id":"74","depthFromRoot":0,"entity":{"type":"concept","slug":"coste-de-la-deuda","term":"Coste de la deuda","excerpt":"Tipo de interés efectivo que paga una empresa por su deuda financiera, ajustado por el beneficio fiscal de los intereses."}}],"edges":[]},"relatedNews":[],"relatedEntities":[]}