Investing for Beginners , investing

Cost of debt shows what the capital cost of the company for its debt capital is. Basically company’s capital consists of two parts: debt capital and equity capital. (A mixed capital like mezzanine financing is also possible). Each those two parts have their own cost and both are important for shareholders and affect company’s value. The cost of equity and the debt cost are necessary to calculate weighted average capital cost (WACC) which is commonly used in any DCF analysis. 

There are two main types of debt cost:

• Before tax cost of debt 
• After tax cost of debt

The cost of company’s debt is equal to the effective interest rate that is paid for company’s financial liabilities. If company does not have any financial debts, then it has no cost of debt. Financial debt is the one for which company has to pay interest (issued bonds, bank loans, financial lease and similar). If company has some debt, but it doesn’t have to pay any interest for it, then it means such debt is not a financial debt and should not be included in the cost of debt calculations. Read more how to calculate the cost of debt:

• Cost of debt calculation
• Cost of debt formula

The cost of debt is an important ratio not only for DCF valuation. This cost is important for the company itself. Usually more risky companies have to pay higher interest rate for its debt and nothing else but the market can determine the risk of the company the best. Usually higher interest rate for the debt is paid by the company that has a lot of financial debt and high debt to equity or debt to EBITDA ratios. Such company may get in a trouble, because it has a lot of debt and has to pay high cost for it, so it means that such company has to pay a lot of interest and it may hurt its cash flow and balance sheet.