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When estimating a company's Cost of Debt for a Weighted Average Cost of Capital (WACC) calculation we normally look into its bond yield. But for a private company with 100% debt capital structure, will the cost of debt be simply equal to the interest rate? If not why?

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  • $\begingroup$ Yes I'd appreciate that $\endgroup$
    – Metrician
    Commented Nov 20, 2019 at 21:18

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Let's address your question in a canonical manner. Say that:

  1. the required rate of return of (private) investors is denoted by $r$.
  2. the interest rate or the cost of debt is denoted by $r_D$ (naturally $r_D < r$)
  3. the share of debt in the capital structure of the company is denoted by $X\%$
  4. the corporate tax rate is denoted by $T_c$

It follows that the average cost of capital (average over equity and debt), $r'$, is such that

$r' = X\% r_D (1-T_c) + (1-X\%) r$


In your case, $X\% = 100\% = 1$, then $r' = r_D(1-T_c)$.

[...] will the cost of debt be simply equal to the interest rate? If not why?

No. Because of $T_c$, the corporate tax rate being potentially non-zero.

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  • $\begingroup$ Any question @Metrician ? $\endgroup$
    – keepAlive
    Commented Nov 20, 2019 at 22:09
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    $\begingroup$ No that was very clear. Thanks a lot. $\endgroup$
    – Metrician
    Commented Nov 20, 2019 at 22:12
  • $\begingroup$ @Metrician and keepAlive, there is another issue besides tax. As Berk & DeMarzo note in Chapter 12 of "Corporate Finance" 4th ed. (see box "Common Mistake" on p. 450), using the debt yield as its cost of capital is a mistake. This is because the interest payments and the repayment of the principal are only promised, not actual. In case of a bankruptcy, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate. $\endgroup$ Commented Oct 15, 2022 at 13:23
  • $\begingroup$ @keepAlive, I believe there is another issue besides tax. See my answer. $\endgroup$ Commented Oct 15, 2022 at 13:32
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@keepAlive's answer includes a good point about tax but misses another, more subtle issue. As Berk & DeMarzo note in Chapter 12 of "Corporate Finance - 5th Global Edition" (see box "Common Mistake" on p. 454), using the debt yield as its cost of capital is a mistake. This is because the interest payments and the repayment of the principal are only promised, not actual. In case of a bankruptcy, these payments may be reduced. Therefore, the actual cost of capital is lower than the interest rate on the loan.

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This issue is minor to the point that it can be neglected for relatively safe debt (for sure if rated AAA or AA, mostly so if rated A and BBB, according to Table 12.2 on p. 454), but can become pretty significant for high-risk debt (BB and lower, ibid.).

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