The Cost of Debt

The cost of debt measures the current cost to the firm of borrowing funds to finance projects. In general terms, it is determined by the following variables:

(1) The current level of interest rates: As interest rates rise, the cost of debt for firms will also increase.

(2) The default risk of the company: As the default risk of a firm increases, the cost of borrowing money will also increase.

(3) The tax advantage associated with debt: Since interest is tax deductible, the after-tax cost of debt is a function of the tax rate. The tax benefit that accrues from paying interest makes the after-tax cost of debt lower than the pre-tax cost. Furthermore, this benefit increases as the tax rate increases. After-tax cost of debt = Pre-tax cost of debt (1 - marginal tax rate)

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