FINANCE • PRACTICAL BUSINESS GUIDES
Cost of Debt: Formula, Example, and After-Tax Calculation
By Taylor Frizzell, MBA • October 21, 2026
Cost of debt is the current return lenders require to finance a company. For WACC, analysts generally estimate a forward-looking borrowing cost and adjust for usable interest tax benefits. That is different from dividing last year’s interest expense by last year’s debt.
Pretax and after-tax formulas
After-tax cost of debt = Pretax cost of debt × (1 − Marginal tax rate)
This shortcut assumes the interest deduction is available and the company can use the tax benefit on the relevant timetable. It is not a statement that every borrower receives the same tax shield. When deductions are limited or benefits are delayed, model the actual expected benefit rather than applying the shortcut automatically.
Worked example: 6% becomes 4.5%
A hypothetical company can borrow $400,000 at 6% annually. Assume a 25% marginal tax rate, full current interest deductibility, no fees, and an interest-only balance throughout the year.
| Item | Calculation | Result |
|---|---|---|
| Annual cash interest | $400,000 × 6% | $24,000 |
| Tax saving | $24,000 × 25% | $6,000 |
| Net economic interest cost | $24,000 − $6,000 | $18,000 |
| After-tax rate | $18,000 ÷ $400,000 | 4.5% |
The lender still receives $24,000. The tax benefit reduces the borrower’s economic cost; it does not change the contractual interest payment. Principal repayment is a separate cash commitment and is not included in the interest tax shield calculation.
Choose the right borrowing rate
- New borrowing quote: use financing that matches the company’s currency, maturity, credit quality, collateral, and seniority. Include material fees when evaluating the transaction’s effective financing cost.
- Traded bond: yield to maturity can be a starting estimate for plain debt. Coupon rate is based on face value; yield also reflects the market price. Callable, distressed, or complex debt requires more analysis.
- Comparable credit: when no direct quote exists, use defensible comparable yields or a risk-free curve plus a credit spread. Explain the differences and avoid double-counting a spread already included in the quoted yield.
Debt issued at a 4% coupon years ago may now require 7% from investors. Using the old coupon in a current WACC can understate the opportunity cost of debt capital. Conversely, interest expense divided by average debt may be useful for historical analysis but can mix old rates, fees, leases, changing balances, and financing arrangements.
Connect it to WACC
Use the same hypothetical financing example as our Cost of Equity guide: $600,000 market-value equity costing 10%, plus $400,000 debt costing 6% pretax, with a 25% usable tax rate.
WACC = 60% × 10% + 40% × 6% × (1 − 25%) = 7.8%.
Do not apply the tax adjustment twice. If 4.5% is already the after-tax debt cost, its weighted contribution is 40% × 4.5% = 1.8%. Add the equity contribution of 6% to obtain 7.8%. Use WACC only for cash flows and risks consistent with its assumptions.
Tax-benefit sensitivity
| Usable tax benefit rate | Pretax debt cost | After-tax shortcut |
|---|---|---|
| 0% | 6% | 6.0% |
| 20% | 6% | 4.8% |
| 25% | 6% | 4.5% |
| 30% | 6% | 4.2% |
These are illustrative cases, not current tax advice or market rates. The marginal rate relevant to the next dollar of deductible interest can differ from an effective tax rate calculated from reported tax expense.
Why cheaper debt does not mean unlimited borrowing
More debt creates fixed commitments and can raise default risk, lender spreads, and shareholders’ required return. Covenants, collateral, refinancing dates, and floating-rate exposure matter. Compare cash available for interest and principal using DSCR, and consider downside scenarios rather than judging debt only by its tax-adjusted percentage.
Common mistakes
- Confusing the coupon, current yield, yield to maturity, and effective financing cost.
- Using a historical book ratio as a current borrowing quote without explanation.
- Assuming deductions always produce immediate cash tax savings.
- Including principal repayment in interest expense.
- Mixing pretax and after-tax inputs or mismatching forecast currency.
- Ignoring fees and refinancing risk when comparing actual loan offers.
Frequently asked questions
Is cost of debt the same as interest expense?
No. Interest expense is an accounting amount for a period. Cost of debt is a rate used to assess financing or valuation, with assumptions about current required returns and taxes.
Is debt always cheaper than equity?
Debt often has senior claims and may receive tax benefits, but pricing depends on credit risk and financing terms. Financial distress can make borrowing extremely expensive or unavailable.
Should a floating-rate loan use today’s rate forever?
No. Forecast the reference rate and contractual spread or use a consistent valuation approach that reflects repricing. Stress-test higher rates and refinancing.
Sources and next steps
CFA Institute: Cost of Capital, Advanced Topics explains methods and the importance of marginal tax assumptions. The numerical examples above are original and hypothetical.
Continue with Capital Structure, Cost of Equity, and the Finance hub.