Cost of debt is the effective interest rate a company pays on its borrowings. Because interest is tax-deductible, the figure that feeds into WACC is the after-tax cost of debt: the pre-tax rate multiplied by one minus the tax rate. It is typically the cheapest source of financing a company has.
Worked example
A company pays 6% interest on its debt and has a 25% tax rate. After-tax cost of debt = 6% × (1 − 0.25) = 4.5%.
Why it matters
The tax deductibility of interest is why debt lowers WACC up to a point — this is the 'tax shield'. Beyond that point, rising default risk pushes the cost of both debt and equity up.
Frequently asked questions
Either divide total interest expense by total debt, or use the yield to maturity on the company's outstanding bonds, which reflects what the market currently charges it to borrow.