Cost of Debt Ratio

Cost of Debt, Cost of Debt Ratio, or Average Cost of Debt Ratio is the term normally and simply refers to the interest expense over a given period as a percentage of the average outstanding debt over the same period. For example: cost of interest divided by average outstanding debt.

The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only.

The cost of debt formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate.

Updated On: 09.10.04