Cost of Debt

The cost of debt is computed by taking the rate on a risk free bond whose duration and
conditions match the term structure of the corporate debt, then adding a default
premium due to the risk factor involved in that investment. This default premium will
rise as the amount of debt increases in the capital structure of the entity.

Since in most cases debt expense is a deductible expense for tax purpose, the cost of
debt is computed as an after tax cost to make it comparable with the cost of equity
(earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax
rate. Common terms used in this context are:

 Bonds: A bond is a long term debt or security. Bonds issued by the government
do not have any risk of default. The government honors obligations of its bonds.
Bonds of the public sector are secured but not risk free. In case of bonds and
debentures, the rate of interest is fixed and known to investors.
 Debentures: Bonds of the private sector are called debentures in India.
 Maturity period: The principal of a bond with maturity is payable after a
specified period, called maturity period.

Characteristics of a Bond/Debenture

Characteristics
Market value
Face value Redemption The price at
Interest rate Maturity
A bond or value which bond or
It is fixed and A bond or
debenture is The value that debenture is
known to debenture is
generally a bondholder currently
bondholders generally
issued at a par or debenture traded in a
or debenture issued for a
value of Rs. holder will get stock
holders. specified
100 or Rs.1000 on maturity is exchange is
Interest paid period of time.
and interest is called called the
on a bond is It’s repaid on
paid on face redemption or market value
tax deductible maturity
value maturity value of the bond or
debenture
*A bond or debenture may be redeemed at par or at premium (more than par value) or
at discount (less than par value)

*Market value maybe different from par value or redemption value

Cost of Debt classification

COST OF DEBT

COST OF VALUE OF
DEBENTURES BONDS

Cost of Cost of
Bond
Irredeemable Redeemable
Amortisation
Debentures Debentures

1) Cost of Debentures

The cost of debentures and long term loans is the contractual interest rate adjusted
further for the tax liability of the company. When the firm employs debt, it must ensure
that common shareholders’ earnings are not diluted. To keep the earnings unchanged,
the firm must earn a return equal to the interest rate of debt. If the firm earns less than
the interest rate, market share price would be adversely affected. In calculating
weighted average cost of capital, cost of debt after tax should be used.

*The higher the interest rates, lower the amount of tax payable by the company.

*The post tax cost of debt and not pre tax cost of debt must be used for all purposes.

The cost of debentures is further classified into the following:

a) Cost of Irredeemable Debentures: Cost of debentures not redeemable during

the life time of a company

Kd = I/ NP (1-t)

Where Kd = cost of debt after tax, I= annual interest rate, NP= Net proceeds of
debentures, t= tax rate

b) Cost of Redeemable Debentures: If debentures are redeemable after the expiry

of a fixed period, the cost of debentures would be:

Kd= {I (1 – t) + (RV – NP)/ N} / {(RV + NP) /2}

Where I = annual interest payment, NP= Net proceeds of debentures, RV= Redemption
value of debentures, t = tax rate , N= life of debentures

2) Value of Bonds

It is comparatively easy to find out the present value of a bond since its cash flows and
discount rates can be determined easily. If there is no risk of default, then there is no
difficulty in calculating the cash flows associated with a bond. The expected cash flows
consist of annual interest payments plus repayment of principal. The appropriate
capitalization or discount rate would depend upon the risk of the bond. The risk in
holding a government bond is less than the risk associated with a debenture issued by a
company. Therefore, a lower discount rate would be applied to the cash flows of the
government bond and a higher rate to the cash flows of the company debenture.

a) Bond Amortization

A bond may me amortized every year. Principal is repaid every year rather than at
maturity. The principal is repaid every year rather than at maturity. In such a situation,
the principal will go down with annual payments and interest will be computed on the
outstanding amount. The cash flows of the bond will be uneven. Formula for bonds
amortized every year:

Vb= C1/ (1+Kd)1 + C2/ (1+Kd)2 + Cn/( 1+ Kd)n = ∑ Ct / (1+Kd)t

FORMULAs USED:

1. Before-tax cost of debt:

1000−N d
I+
n
kd =
N d + 1000
2
Where, I = annual interest (in dollars)

Nd = net proceeds from sale of debt

n = number of years to bond’s security

2. After- tax cost of debt:

k i =k d∗(1−T )

Where, T = tax rate

Cost of Preference Shares
The cost of preference share capital is the dividend expected by its holders. Though
payment of dividend is not mandatory, nonpayment will result in exercise of voting
rights by them. The payment of preference dividend is not adjusted for taxes as they are
paid after taxes and is not deductible. The cost of preference share capital is calculated
by dividing the fixed dividend per share by the price per preference share.

Kp= preferred stock dividend/ mkt price of preferred stock ( 1- floatation cost)

a) Cost Of Irredeemable Preference Shares

Kp= PD/PO

Where PD= annual preference dividend, PO= net proceeds in issue of preference shares

b) Cost of Redeemable Preference Shares

Kp= {PD + ( RV – NP) / N}/{RV+NP/2}

Where: PD= annual preference dividend, RV= redemption value of preference shares,
NP= net proceeds on issue of preference shares, N= life of preference shares

However, since dividend of preference shares is not allowed as deduction from income
for income tax purposes, there is no question of tax advantage in this.

Thus, in the case of cost of debt and cost of preference shares, cost of capital is
calculated by reference to the obligations incurred and proceeds received. The net
proceeds received must be taken into account in working out the cost of capital.

FORMULA USED:

Dp
k p=
Np
Where, Kp = cost of preferred equity

Np = net proceeds from the sale of shares

Dp = annual dollar dividend