Estimating the Cost of Debt
The interest rate stamped on a company's existing bonds is a stale, historical number, not its current cost of debt — the right figure is what the company would pay to borrow today, and it needs a tax adjustment before it belongs in WACC.
An easy mistake in a WACC calculation is pulling the coupon rate off a company's balance sheet and calling it the cost of debt. A bond issued five years ago at a 4% coupon tells you what the company paid to borrow then; interest rates and the company's own creditworthiness have both likely moved since. WACC needs a forward-looking number: what would this company pay to borrow new money today?
Cost of debt is today's market borrowing rate, not a historical coupon — and it must be adjusted for the tax shield interest provides, since interest is tax-deductible and equity dividends are not. The after-tax cost of debt, not the pre-tax rate, is what belongs in WACC.
Getting the pre-tax rate
Three common routes, in order of reliability: if the company has actively-traded bonds, use their current yield to maturity directly — that's the market's live estimate of the company's borrowing cost. If bonds exist but trade too thinly to trust the quoted yield, use the company's credit rating and look up the typical spread over the risk-free rate that rating commands in the current market. If there's no rating and no bonds at all (common for smaller or private companies), estimate a synthetic rating from interest coverage ratios, and apply the typical spread for that synthetic rating tier instead.
Applying the tax shield
In words: because interest payments reduce taxable income, the government effectively subsidizes part of every interest dollar paid — multiplying by one minus the tax rate reflects that only the after-tax portion is a true economic cost to the company.
Worked example
A mid-cap industrial company has bonds outstanding, but they trade too infrequently for the quoted yield to be trusted. The company carries a BBB credit rating, and BBB-rated debt is currently trading at a spread of 2.0% over the 10-year Treasury yield of 4.2%.
Pre-tax cost of debt = 4.2% + 2.0% = 6.2%. At a 25% marginal tax rate:
That 4.65% is the figure that goes into the WACC calculation — noticeably lower than the 6.2% pre-tax rate, purely from the interest tax shield, and quite different from whatever coupon happens to be printed on the company's existing bonds.
What this means in practice
Getting cost of debt wrong understates or overstates WACC directly, which flows straight through to enterprise value. Analysts should re-check the market-implied spread periodically — a company's creditworthiness and the broader spread environment both move over time, and an old cost-of-debt estimate can go stale just as fast as an old coupon rate would.
Using the coupon rate on existing debt as the cost of debt is one of the most common WACC errors — it reflects the rate at issuance, not the rate the market would charge today, and the two can differ enormously if rates or the company's credit quality have moved since.
Further reading
- Damodaran, Investment Valuation (ch. 7, estimating cost of debt)