# Cost of Debt Equation: Formula, Examples, and How It's Used in WACC

Published: 2026-01-19
Author: Warren Team
URL: https://www.heywarren.com/blog/cost-debt-equation

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The cost of debt is the effective interest rate a company pays on its borrowed funds, and one of the two key inputs alongside [cost of equity](/blog/cost-of-equity-equation) in the **[Weighted Average Cost of Capital](/blog/how-to-calculate-weighted-cost-of-capital) (WACC)** calculation. Because interest payments are tax-deductible in most jurisdictions, finance professionals use the **after-tax cost of debt** in WACC: **Cost of Debt (after-tax) = rd × (1 − tax rate)**, where rd is the pre-tax yield on the debt. A company with a 6% interest rate on its bonds and a 25% corporate tax rate has an after-tax cost of debt of 4.5%, the effective cost once the tax shield is accounted for. Understanding the cost of debt equation is fundamental for corporate finance, capital budgeting, and valuation.

## The Cost of Debt Formula

**Pre-tax cost of debt**:

![How the pre-tax cost of debt is adjusted by the tax shield to produce the after-tax figure used in WACC.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20660%20125%22%20width%3D%22660%22%20height%3D%22125%22%20role%3D%22img%22%3E%3Ctitle%3EFlow%20diagram%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%2230%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22115%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EPre-Tax%20Rate%3C%2Ftext%3E%3Ctext%20x%3D%22115%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3Erd%20%28YTM%29%3C%2Ftext%3E%3Cline%20x1%3D%22205%22%20y1%3D%2262.5%22%20x2%3D%22237%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22244%2C62.5%20235%2C57.5%20235%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22245%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22330%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ETax%20Shield%3C%2Ftext%3E%3Ctext%20x%3D%22330%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3E%C3%97%20%281%20%E2%88%92%20T%29%3C%2Ftext%3E%3Cline%20x1%3D%22420%22%20y1%3D%2262.5%22%20x2%3D%22452%22%20y2%3D%2262.5%22%20stroke%3D%22%2364748b%22%20stroke-width%3D%222%22%2F%3E%3Cpolygon%20points%3D%22459%2C62.5%20450%2C57.5%20450%2C67.5%22%20fill%3D%22%2364748b%22%2F%3E%3Crect%20x%3D%22460%22%20y%3D%2225%22%20width%3D%22170%22%20height%3D%2275%22%20rx%3D%2210%22%20fill%3D%22white%22%20stroke%3D%22%232563eb%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22545%22%20y%3D%2258.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EAfter-Tax%20Cost%3C%2Ftext%3E%3Ctext%20x%3D%22545%22%20y%3D%2278.5%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2211%22%20fill%3D%22%2364748b%22%3Erd%20%C3%97%20%281%20%E2%88%92%20T%29%3C%2Ftext%3E%3C%2Fsvg%3E)

*How the pre-tax cost of debt is adjusted by the tax shield to produce the after-tax figure used in WACC.*

> **rd = Interest Expense / Average Debt Outstanding**

Or, more precisely for new debt issuance:

> **rd = [Yield to Maturity](/blog/formula-of-ytm) (YTM) on the debt**

**After-tax cost of debt** (used in WACC):

> **rd(after-tax) = rd × (1 − T)**

Where:
- **rd** = pre-tax cost of debt (YTM or interest rate)
- **T** = effective corporate tax rate

**Example**:
- Company issues a 10-year bond at 7% coupon
- Corporate tax rate: 28%
- After-tax cost of debt = 7% × (1 − 0.28) = **5.04%**

## Two Approaches to Calculating Cost of Debt

**Approach 1, Yield to Maturity (YTM)**:
For companies with publicly traded bonds, the market yield (YTM) is the most accurate pre-tax cost of debt. It reflects current market conditions and the company's current credit risk, not historical coupon rates that may no longer be relevant.

- Company's 10-year bond: face value $1,000, coupon 6%, currently trading at $950
- YTM ≈ 6.6% (higher than coupon because bond trades at discount)
- After-tax cost of debt = 6.6% × (1 − 0.25) = **4.95%**

**Approach 2, Debt Rating Approach**:
For companies without publicly traded debt, analysts use the company's credit rating to estimate the cost of debt based on typical spreads over the risk-free rate (US Treasury yield):

| Credit Rating | Typical Spread Over 10-Yr Treasury | If Treasury = 4.3% |
|---|---|---|
| AAA | +0.4% | 4.7% |
| A | +1.0% | 5.3% |
| BBB | +1.8% | 6.1% |
| BB (high yield) | +3.5% | 7.8% |
| B | +5.5% | 9.8% |
| CCC | +9.0%+ | 13.3%+ |

For private companies or those with complex capital structures, analysts may also use the **synthetic rating approach**, estimating a credit rating from interest coverage ratio (EBIT / Interest), then applying the corresponding spread.

## Cost of Debt in WACC

[WACC weights](/blog/wacc-weights) the cost of debt and equity by their proportions in the capital structure:

![Equity and debt contributions to the 7.8% WACC in the example with 60/40 capital structure.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20800%20210%22%20width%3D%22800%22%20height%3D%22210%22%20role%3D%22img%22%3E%3Ctitle%3EComparison%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Ctext%20x%3D%22230%22%20y%3D%2257.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EEquity%20Cost%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%2225%22%20width%3D%22450%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22702%22%20y%3D%2257.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%232563eb%22%3E%256%3C%2Ftext%3E%3Ctext%20x%3D%22230%22%20y%3D%22152.5%22%20text-anchor%3D%22end%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EDebt%20Cost%3C%2Ftext%3E%3Crect%20x%3D%22240%22%20y%3D%22120%22%20width%3D%22135%22%20height%3D%2255%22%20rx%3D%226%22%20fill%3D%22%237c3aed%22%2F%3E%3Ctext%20x%3D%22387%22%20y%3D%22152.5%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22%237c3aed%22%3E%251.8%3C%2Ftext%3E%3C%2Fsvg%3E)

*Equity and debt contributions to the 7.8% WACC in the example with 60/40 capital structure.*

> **WACC = (E/V) × re + (D/V) × rd × (1 − T)**

Where:
- E = market value of equity
- D = market value of debt
- V = E + D (total firm value)
- re = cost of equity
- rd = pre-tax cost of debt
- T = corporate tax rate

**Example, WACC Calculation**:
- Equity: $600M (60% of capital structure)
- Debt: $400M (40%)
- Cost of equity (CAPM): 10%
- Pre-tax cost of debt: 6%
- Tax rate: 25%

> WACC = (60% × 10%) + (40% × 6% × 75%) = 6.0% + 1.8% = **7.8%**

## What Affects the Cost of Debt?

**Credit quality**: Higher-rated companies borrow at lower rates. Investment-grade debt (BBB− and above) typically costs 150–300 bps less than speculative-grade (BB and below).

![Key factors that raise or lower a company's borrowing cost.](data:image/svg+xml,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20viewBox%3D%220%200%20760%20211%22%20width%3D%22760%22%20height%3D%22211%22%20role%3D%22img%22%3E%3Ctitle%3EHierarchy%3C%2Ftitle%3E%3Crect%20width%3D%22100%25%22%20height%3D%22100%25%22%20fill%3D%22%23f8fafc%22%2F%3E%3Crect%20x%3D%22300%22%20y%3D%2220%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22%232563eb%22%2F%3E%3Ctext%20x%3D%22380%22%20y%3D%2254%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2214%22%20font-weight%3D%22700%22%20fill%3D%22white%22%3ECost%20of%20Debt%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20110%20105.5%20L%20110%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%2230%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22110%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ECredit%20Quality%3C%2Ftext%3E%3Ctext%20x%3D%22110%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ERating%20%26amp%3B%20spread%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20290%20105.5%20L%20290%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22210%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22290%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EMaturity%3C%2Ftext%3E%3Ctext%20x%3D%22290%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ETerm%20premium%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20470%20105.5%20L%20470%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22390%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22470%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3ESeniority%3C%2Ftext%3E%3Ctext%20x%3D%22470%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3ESecured%20vs.%20unsecured%3C%2Ftext%3E%3Cpath%20d%3D%22M%20380%2078%20L%20380%20105.5%20L%20650%20105.5%20L%20650%20133%22%20stroke%3D%22%23cbd5e1%22%20stroke-width%3D%222%22%20fill%3D%22none%22%2F%3E%3Crect%20x%3D%22570%22%20y%3D%22133%22%20width%3D%22160%22%20height%3D%2258%22%20rx%3D%228%22%20fill%3D%22white%22%20stroke%3D%22%230891b2%22%20stroke-width%3D%222%22%2F%3E%3Ctext%20x%3D%22650%22%20y%3D%22158%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2213%22%20font-weight%3D%22600%22%20fill%3D%22%230f172a%22%3EMarket%20Rates%3C%2Ftext%3E%3Ctext%20x%3D%22650%22%20y%3D%22176%22%20text-anchor%3D%22middle%22%20font-family%3D%22system-ui%2C-apple-system%2Csans-serif%22%20font-size%3D%2210%22%20fill%3D%22%2364748b%22%3EFed%20policy%20%26amp%3B%20inflation%3C%2Ftext%3E%3C%2Fsvg%3E)

*Key factors that raise or lower a company's borrowing cost.*

**Maturity**: Longer-maturity debt typically carries higher interest rates (upward-sloping yield curve in normal conditions), term premium compensation.

**Secured vs. unsecured**: Secured debt (backed by specific collateral) carries lower rates than unsecured debt. Senior secured bank loans are typically cheapest; subordinated notes are most expensive.

**Market conditions**: The absolute level of interest rates (driven by central bank policy and inflation) directly drives all corporate borrowing costs. A 200 bps rise in the Fed funds rate typically translates into similar increases in investment-grade corporate borrowing costs.

## Common Mistakes in Calculating Cost of Debt

**Using coupon rate instead of YTM**: The coupon rate is historical; YTM reflects current market pricing of credit risk. For valuation purposes, always use YTM (or market-based spreads for non-traded debt).

**Using book value of debt instead of market value**: WACC weights should use market values, not balance sheet (book) values. For most investment-grade companies, the two are similar, but for distressed companies, they can diverge significantly.

**Ignoring off-balance-sheet debt**: Operating leases (post-ASC 842), pension obligations, and [contingent liabilities](/blog/contingent-liabilities) are economically debt-like and should be considered when assessing total cost of debt.

## Authoritative Sources

For deeper background and primary-source data on this topic, the following authoritative sources are useful starting points:

- [IRS](https://www.irs.gov/)
- [SEC](https://www.sec.gov/)

## Conclusion

The cost of debt equation, rd × (1 − tax rate), quantifies the after-tax cost of borrowed capital and is a critical input in WACC and corporate valuation. The pre-tax cost is best estimated from YTM on traded bonds or credit-rating-based spreads for non-traded debt. For related capital structure and valuation concepts, see our guides on [EBITDA adjustments](/blog/ebitda-adjustments) and [calculating EBIT](/blog/calculating-ebit).

Warren at [heywarren.com](https://heywarren.com) helps finance analysts, CFOs, and students calculate cost of debt, build WACC models, and apply capital structure theory to real valuation problems.

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## Related Reading

**More from Warren**:
- [EBITDA Adjustments: What They Are and Why They Matter in M&A](/blog/ebitda-adjustments)
- [Calculating EBIT: Formula, Examples, and How Lenders Use It](/blog/calculating-ebit)
- [Formula for Operating Income: How to Calculate It and Why It Matters](/blog/formula-for-operating-income)

**Authoritative sources**:
- [Damodaran, Cost of Capital Data](https://pages.stern.nyu.edu/~adamodar/)
- [SEC, Corporate Bond Market Data](https://www.sec.gov/cgi-bin/browse-edgar)
- [Federal Reserve, Corporate Bond Spreads](https://www.federalreserve.gov/releases/h15/)