how the cost of debt works
debt is any money owed by one entity to another having debt is unavoidable for many entities and is rather common in fact companies and individuals may use debt to make large purchases or investments for further growth for corporations debt is one part of their capital structures which also includes equity capital structure deals with how a firm finances its overall operations and growth through different sources of funds which may include debt such as bonds or loans the cost of debt measure is helpful in understanding the overall rate being paid by a company to use these types of debt financing the measure can also give investors an idea of the company s risk level compared to others because riskier companies generally have a higher cost of debt the cost of debt is generally lower than cost of equity formula and calculation of cost of debtthere are a couple of different ways to calculate a company s cost of debt depending on the information available one way to calculate the cost of debt is by using the formula for the after tax cost of debt the risk free rate of return is the theoretical rate of return of an investment with zero risk most commonly associated with u s treasury bonds a credit spread is a difference in yield between a u s treasury bond and another debt security of the same maturity but different credit quality 1this formula is useful because it takes into account fluctuations in the economy as well as company specific debt usage and credit rating if the company has more debt or a low credit rating then its credit spread will be higher for example say the risk free rate of return is 1 5 and the company s credit spread is 3 its pretax cost of debt is 4 5 if its tax rate is 30 then the after tax cost of debt is 3 15 we can calculate this in the following way 