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Definition: Cost of Debt
Most firms employ several types of capital, with the components made up of common stock and preferred stock along with debt being the three most common types. The required return in each component is called component cost with the cost of capital being the weighted average of the various component costs.
The cost of debt is the required rate of return for the debt holders. Companies use both fixed and floating rate debt, straight and convertible debt with and without sinking funds and each form has a somewhat different cost.
For example, Company X is trying to estimate the component cost of debt. Most financial managers begin by discussing current and prospective interest rates with investment bankers. If the bankers believe that a new 30 year, non-callable, straight bond issue will require a 10% coupon rate with semi-annual payments and that it can be offered to the public at Rs. 1,000 par value, then the estimate of cost of debt for Company X is 10%. This 10% is the cost of the marginal debt issued by the company and may not be equal to the average rate at which X has previously issued debt.