What does the cost of debt formula include?

• A. Risk-free rate and market return only
• B. (Risk-free rate + risk premium) * (1 - T)
• C. Cost of equity only
• D. (Risk-free rate - risk premium) / T

Answer: (B)

The cost of debt formula includes the risk-free rate and a risk premium representing the additional risk associated with borrowing. This is vital because lenders expect compensation for the risk of default. The formula also incorporates a tax adjustment factor, specifically (1 - T), where T is the tax rate. This reflects the tax-deductibility of interest expenses, effectively lowering the net cost of debt for a company.

So, when calculating the cost of debt, you start with the risk-free rate, add the risk premium to reflect the credit risk of the borrower, and then multiply by (1 - T) to account for the tax advantage. This comprehensive view of the cost associated with borrowing provides a more accurate assessment of the financial implications of debt.