Cost of debt

The cost of debt is the effective interest rate a company pays on its interest-bearing obligations: bank loans, bonds, finance leases and shareholder loans. It is estimated from the yield the company would pay on new borrowing today, or as interest expense divided by average financial debt over the period; its level reflects the borrower's credit risk, security package, duration and market conditions. The cost of debt formula used in valuation applies the tax shield: after-tax cost of debt = kd × (1 - effective tax rate), because interest is tax-deductible while dividends are not.

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In the WACC, the after-tax cost of debt is weighted by the share of debt in the capital structure, alongside the cost of equity weighted by the equity share, with weights ideally measured at market value on the basis of net financial debt and the resulting gearing. The cost of debt is almost always lower than the cost of equity, since lenders rank ahead of shareholders and bear less risk; this is why moderate leverage lowers the WACC. In Switzerland, interest deductibility is framed by the thin capitalisation safe harbour ratios and the safe harbour interest rates published annually by the Federal Tax Administration for shareholder loans: exceeding them can recharacterise excess interest as a hidden dividend and reduce the effective tax shield.

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Worked example: a Swiss SME carries a CHF 6.0 million bank loan at 4.2% and a CHF 1.5 million finance lease at 3.8%. Pre-tax cost of debt = (6.0 × 4.2% + 1.5 × 3.8%) / 7.5 = 4.1%. With a 14% effective tax rate, the after-tax cost of debt = 4.1% × (1 - 0.14) = 3.5%. At a 35% debt weight, debt contributes 3.5% × 0.35 = 1.2% to the WACC, the balance coming from the cost of equity weighted at 65%.

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Hectelion determines the cost of debt with precision, distinguishing financing sources and incorporating applicable tax shields by jurisdiction.