What is Cost of Debt?
Cost of debt is the effective rate that a company pays on its borrowings — bank loans, bonds, sukuk — usually expressed on an after-tax basis because interest is tax-deductible. It is one of the two main inputs (alongside cost of equity) in the weighted average cost of capital.
How It Works
- Pre-tax cost = yield to maturity on outstanding debt, or the rate a new issue would carry
- After-tax cost = Pre-tax cost × (1 − Marginal tax rate)
- Driven by risk-free rate, credit spread, and tenor
- Companies with stable cash flows and strong covenants pay less
- Used in WACC, NPV, and acquisition pricing
Saudi Context
In Saudi Arabia, cost of debt for corporates is benchmarked off SAIBOR plus a credit spread. For non-Saudi shareholder portions subject to 20% corporate income tax, the tax shield reduces after-tax cost; the Zakat-paying portion sees no equivalent shield. ZATCA transfer-pricing rules limit excessive related-party interest as a tool to shift profit.
Example
A Saudi company issues SAR 500M sukuk at a 6% profit rate. Its non-Saudi shareholder portion of taxable income is subject to 20% corporate tax. The after-tax cost of that debt = 6% × (1 − 20%) = 4.8%, used as the debt input to WACC.