Cost of Debt
cost of debt is the interest a company pays on its borrowings. it is expressed as a percentage rate. in addition, cost of debt can be calculated as a before-tax rate or an after-tax rate. because interest is deductible for income taxes, the cost of debt is usually expressed as an after-tax rate. the formula for the cost of debt is the sum of the risk-free rate plus the credit spread times one minus the tax rate. different factors affect the different components in the formula. fluctuations in the economy affect the risk-free rate. the amount of the company's borrowing and the credit rating affect the credit spread. this is because more debt and lower credit rating means a greater chance of default and thus more risk. the higher the default risk, the more lenders will charge to loan money. government policy affects the tax rate. assume billco incorporated has a current credit spread of 3%. if the risk-free rate is 2% and the corporate tax rate is 35%, then billco's before-tax cost of debt is 5% and its after-tax cost of debt is 3.25%. if the economy slows, billco's cost of debt will be affected. if billco has to incur more debt to keep operating, its credit spread will increase. if the government raises tax rate to maintain tax revenue, that will also affect billco's cost of debt. assuming billco's credit spread increases to 5%, the risk-free rate goes to 4% and the government raises the tax rate to 40%, these rate changes resulting from a slow economy will cause billco's cost of debt to rise to 5.4%.
- cost of debt・・・負債コスト