The cost of debt is the effective interest rate a company pays on its borrowed money, after accounting for the tax savings that come from deducting interest. You calculate it in two steps: divide total annual interest expense by total debt to get the pre-tax rate, then multiply by one minus the tax rate to get the after-tax rate that actually matters for decisions.
A corporation paying 5% on its loans at a 21% federal tax rate has an after-tax cost of debt of roughly 3.95%. The gap between the 5% the lender sees and the 3.95% the business actually bears is the whole point of the calculation.
What the Number Represents
Every interest-bearing obligation a company carries feeds into this figure: long-term bonds, bank term loans, revolving credit facilities, equipment financing. The cost of debt rolls all of them into a single percentage so you can see what borrowed capital really costs the business as a whole.
You find the inputs in two places on a public company’s annual 10-K filing with the SEC. The balance sheet shows total debt in the liabilities section. The income statement shows interest expense. For a private business, the same two numbers come from your own books.
The Pre-Tax Formula
The pre-tax calculation is simple division:
Pre-Tax Cost of Debt = Total Interest Expense ÷ Total Debt
Say a company carries $10 million in total debt and paid $600,000 in interest last year. The pre-tax cost of debt is $600,000 ÷ $10,000,000 = 6%.
That 6% is a blended figure. The company might actually have a 4% bond, a 7% bank loan, and a floating-rate line of credit sitting underneath it, but the formula collapses the whole mix into one weighted rate. Make sure the debt total includes both fixed and variable obligations, and that interest expense captures accrued interest, not only cash paid during the year.
The After-Tax Formula and the Tax Shield
Interest on business debt is generally deductible under Section 163 of the Internal Revenue Code.1Office of the Law Revision Counsel. 26 USC 163 – Interest That deduction cuts the company’s tax bill, which is why the real cost of borrowing is lower than the stated rate. Finance people call this the tax shield.
After-Tax Cost of Debt = Pre-Tax Cost of Debt × (1 − Tax Rate)
The federal corporate tax rate is a flat 21%.2Internal Revenue Service. Publication 542 (01/2024), Corporations Running the earlier example through: 6% × (1 − 0.21) = 6% × 0.79 = 4.74%. The deduction knocks more than a full point off the borrowing cost.
State corporate income tax widens the shield further. Most states tax corporate income, and interest is typically deductible at the state level too. Rates range from zero in a handful of states to over 11% at the top. A company in a state with a 6% rate faces a combined marginal rate of roughly 27%, bringing the after-tax cost of that same 6% debt down to about 4.38%. Use your combined federal-plus-state marginal rate for the sharpest number.
For a pass-through entity like an S corporation or a sole proprietorship, business income flows to the owner’s personal return, so plug in the owner’s individual marginal rate rather than 21%.
When the Interest Deduction Is Capped
The shield has a ceiling. Section 163(j) limits how much business interest a company can deduct in one tax year. The cap equals the company’s business interest income plus 30% of its adjusted taxable income (ATI). For tax years beginning in 2026, ATI is calculated on an EBITDA-like basis, meaning depreciation, amortization, and depletion are added back before applying the 30% threshold.3Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense That is more generous than the EBIT-based version that applied from 2022 through 2024.
Interest that exceeds the cap is not lost. It carries forward to the next year and can be deducted when there is room under that year’s limit.3Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense For heavily leveraged companies that run up chronic carryforwards, the tax shield is delayed rather than denied, and the real after-tax cost of debt is higher than the simple formula implies. Private equity-backed firms, real estate developers, and companies carrying post-acquisition debt loads tend to feel this most.
Smaller companies escape the cap entirely. If average annual gross receipts for the prior three tax years are $32 million or less, 163(j) does not apply for 2026.4Internal Revenue Service. Revenue Procedure 2025-32 The threshold is indexed for inflation. Businesses under it deduct all interest and can rely on the straightforward after-tax formula.5eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited
Yield to Maturity for Public Bonds
The division method is fine for private companies and quick estimates. For a company with traded bonds, analysts often prefer yield to maturity (YTM), because the coupon rate on a bond was set under market conditions on the day it was issued and may be years stale. YTM reflects what investors demand to hold the debt today.
YTM pulls in four variables: current market price, face value, annual coupon, and years to maturity. When rates rise after issuance, the bond’s price drops below face value and YTM climbs above the coupon rate. When rates fall, the reverse happens. A company might have issued bonds at 4%, but if those bonds now trade at a discount, the market is pricing the true cost of that debt higher than the coupon suggests. When a company has several bond issues outstanding, analysts calculate a weighted average YTM across them.
What Drives the Rate
Two forces set the interest rate a company actually pays: the general level of rates in the economy, and the borrower’s own credit.
Benchmark Rates
The Federal Reserve sets the federal funds rate, the rate banks charge each other overnight.6Federal Reserve. Economy at a Glance – Policy Rate Every corporate loan and bond is priced as a spread above some benchmark, so when the Fed moves, corporate borrowing costs move with it.
Credit Quality
The spread itself depends on the borrower. Rating agencies grade companies on default risk, and the grade translates into a price. A AAA-rated issuer might pay roughly 0.40 percentage points above the risk-free rate. A single-B issuer could pay 3% to 5% or more. Ratings move with leverage, cash flow stability, and the cushion available in a downturn. A downgrade can raise a company’s borrowing cost overnight on debt it already owes, because the market reprices the risk.
How Cost of Debt Feeds Into WACC
Most people calculating cost of debt are really building up to the Weighted Average Cost of Capital. WACC blends the after-tax cost of debt with the cost of equity, weighted by how much of the company’s capital comes from each source.
If a company is financed 40% by debt at an after-tax cost of 4.74% and 60% by equity at 10%, the WACC is (0.40 × 4.74%) + (0.60 × 10%) = 1.90% + 6.00% = 7.90%. That 7.90% is the hurdle rate for new projects. An investment expected to earn less than WACC destroys value, because the capital funding it costs more than the project returns.
Debt is almost always cheaper than equity after the tax deduction, so leaning harder on debt tends to lower WACC. There is a tipping point. As leverage rises, lenders demand more to compensate for default risk, and at some level the climbing cost of debt swamps the WACC benefit. The optimal capital structure sits at the point where WACC is lowest, and borrowing past that point makes the company less efficient, not more.
Small Business Borrowing
The same math works at a smaller scale, usually at higher rates. SBA 7(a) loans cap interest at prime plus 3% for variable-rate loans above $350,000, and up to prime plus 6.5% for loans of $50,000 or less.7U.S. Small Business Administration. Terms, Conditions, and Eligibility Unsecured lines of credit routinely run higher, especially for newer businesses.
A small business under the $32 million gross receipts threshold deducts all of its interest, so the simple after-tax formula gives an accurate answer. Pair it with the correct marginal rate, whether that is 21% for a C corporation or the owner’s individual rate for a pass-through, and the number you get out is the one you can use for pricing projects, comparing financing offers, and deciding whether another dollar of debt is worth taking on.