8.6 : Cost of Debt

The cost of debt is the effective rate a company pays on its total debt. The effective interest rate paid by the company is reduced by its tax rate, lowering the overall cost. The cost of debt is a significant factor for businesses because it affects their financial strategy and ability to manage cash flow.

Unlike equity issuers, debt issuers are legally obligated to repay a predetermined amount by the date specified in the contract, making debt less risky for lenders. This lower risk results in a typically lower cost compared to equity. The cost of equity is usually higher than the cost of debt, and in the event of liquidation, equity holders are paid last. Preferred stock, sitting between debt and common equity in terms of risk, typically carries a cost higher than debt but lower than common equity. Preferred dividend payments are not tax-deductible, making the preferred stock less advantageous than debt from a cost perspective.

Debt can be strategically advantageous for a company due to its cost-saving tax shield and as a tool for financing specific projects or expansions without diluting ownership through issuing new equity. In corporate finance, the cost of debt is a pivotal element in determining the overall cost of capital.