COST OF DEBT

The cost of debt is the rate of interest payable on debt.

Debt may be redeemable or Irredeemable.
Debt may be issued at Par Value (Face value), at Premium or Discount.
Cost of Debt Capital

Kd = Interest Rate =I/P

Principal
Where Kd = Before tax cost of debt
I = Interest Rate
P = Principal

In Case, if the debt is raised at premium or discount, we should consider P as the amount
of net proceeds received from the issue and not the face value of the securities.
The formula may be changed to
Kd = I
SV or NP
Where NP = Net Proceeds, SV = Sale Value
Further, when debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of tax. Hence,
the effective cost of debt is reduced.
Example:
If a company has a debt of Rs. 30,00,000 debentures at 10% and if its EBIT (Earnings
Before Interest and Tax) is Rs. 1 Crore.
Interest = 30,00,000* 0.10 = 3,00,000

With Debt Without Debt

EBIT = 100,00,000 EBIT = 100,00,000
(-) Interest = 3,00,000 (-) Interest = 0
EBT = 97,00,000 EBT = 100,00,000
(-) Tax @30% = 29,10,000 (-) Tax @30% = 30,00,000
EAT = 67,90,000 EAT = 70,00,000
In case if the debt is issued at Premium of 10%
Net Proceeds = 30,00,000 + 10% of 30,00,000
= 30,00,000 + 3,00,000 = 33,00,000
Kd = I = 3,00,000 = 0.090909 *100 = 9.09%
NP 33,00,000
In case if the debt is issued at discount of 10%
Sale Value = 30,00,000 - 10% of 30,00,000
= 30,00,000 - 3,00,000 = 27,00,000
Kd = I = 3,00,000 = 0.1111 *100 = 11.11%
SV 27,00,000

COST OF IRREDEEMABLE DEBT

Before tax cost of debt = Interest
Sale Value (Sale Value) or Net Proceeds (NP)
Kd = I
SV or NP
After tax cost of debt = Interest* (1-tax rate)
Sale Value (Sale Value) or Net Proceeds (NP)
Kd = I * (1 – t)
SV or NP
Where t = tax rate
PROBLEMS
1. SV and Co. raise Rs. 2,00,000 by the issue of 2000, 10% Debentures of Rs. 100 each
payable at par after 10 Years. If the company’s tax rate is say 50%, what is the cost of
the debt to the firm? (10%, 5%)
Solution:

2. X Limited issues Rs. 50,000, 8% debentures at par. The tax rate is 50%. Compute the
cost of debt? (8%, 4%)
Interest = 50,000*8% = 50,000*0.08 = Rs. 4000
Kd = I / SV = 4000/50,000 = 8% (Before tax)
Kd = I/SV (1-t) = 4000 * (1-0.50) = 4%
50000

3. Y Limited issues Rs. 50,000, 8% debentures at a premium of 10%. The tax rate is 40%.
Compute the cost of debt? (7.27%, 4.36%)
Interest = 50,000*8% = Rs. 4000
Net Proceeds = 50,000 + 10% of 50,000 = 50,000 + 5000 = Rs. 55,000
Kd = I / NP = 4000 / 55000 = 0.0727*100 = 7.27%
After Tax rate
Kd = I/NP (1-t) = 4000 * (1-0.40) = 4.36%
55000
Kd = 7.27 * (1-0.40) = 4.36%
4. A Limited issues Rs. 50,000, 8% debentures at a discount of 10%. The tax rate is 50%.
Compute the cost of debt? (8.89%, 4.45%)
Interest = 50,000*8% = 50,000*0.08 = Rs. 4000
SV = 50,000 - 10% of 50,000 = 50,000 – 5000 = 45000
Kd = I / SV = 4000/45,000 = 0.0889 = 8.89% (Before tax)
Kd = I/SV (1-t) = 4000/45000 *(1-0.50) = 4.45%

COST OF REDEEMABLE DEBT

Before Tax

After Tax

Kd = Cost of debt I = Interest t = tax rate f = flotation cost

d = discount Pr = Premium at redemption of debenture
Pi = Premium at Issue of debenture
RV = Redeemable value of debenture (paid at end of maturity period)
SV = Sale value or sale proceeds (Face value of debt – issue expenses)
N = maturity period or duration of the debt instrument
A company issues 10% debentures of Rs. 1000 face value to be redeemed
after 10 years. The debenture is expected to be sold at 5% discount. It will
also involve a floatation cost of 5% of face value. The company tax rate is
35%. What would be the cost of debt?
Face value = Rs. 1000, Interest rate = I = 10% = 10% of 1000 = Rs. 100
Maturity period = 10 Years
Discount = d = Rs.1000 – 5% of 1000 = 1000 – 50 = Rs. 950
Floatation Cost = f = 5% of Rs. 1000 = Rs. 50
Tax rate = 35%
RV = Maturity Value = Rs. 1000
Sale Value = SV = 1000 – 50 – 50 = Rs.900

Before Tax

Kd = 100 + (50+50)/10 = 100+10 = 110 = 0.1157 = 11.57%

(1000 + 900)/2 950 950

Kd = 100 (1-0.35) + (50+50)/10 = 65+10 = 75 = 0.07895 = 7.895%

(1000 + 900)/2 950 950

2. Assume that a company has issued 10%, 10 years debentures with face value of Rs.100.
Calculate the explicit cost of debt for each of the following situations assuming 35%
corporate tax rate:
a) Debentures are sold at par and flotation costs are 5%
b) Debentures are sold at a premium of 10% and flotation costs are 5% of issue price
c) Debentures are sold at discount of 5% and flotation costs are 5% of issue price.

Interest = 10% of Rs. 100 = 0.10*100 =Rs. 10

Tax rate = 35%
N = 10 Years
MV = 100

Debentures are sold at par and flotation costs are 5%

Floatation cost = 5% of face value = 0.05*100 = Rs.5
SV = 100-5 = Rs. 95
Kd = 10 (1 – 0.35) + (5) / 10 = 6.5 + 0.5 = 0.07179 = 7.18%
(100 + 95) / 2 97.5
Debentures are sold at a premium of 10% and flotation costs are 5% of issue price
Net Proceed = 100 + 10*of 100 = 100+10 =110
Floatation cost = 5% of face value = 0.05*110 = Rs.5.5
Pi = Rs.10
SV = 110 – 5.5 = 104.5

Kd = 10 (1 – 0.35) + (5.5-10) / 10 = 6.5 - 0.45 = 0.05916 = 5.916%

(100 + 104.5) / 2 102.25
Debentures are sold at discount of 5% and flotation costs are 5% of issue price.
Discount = Rs. 5
Floatation Cost = 95 * 0.05 = Rs. 4.75
MV = Rs. 100
SV = 100-5 -4.75 = Rs. 90.25

Kd = 10 (1 – 0.35) + (4.75+5) / 10 = 6.5 + 0.975 = 0.07858 = 7.86%

(100 + 90.25) / 2 95.125

A company’s debentures of the face value of Rs.100 bear an 8% coupon rate. Debentures
of this type currently yield 10%.
a. what is the market price of debentures of the company?
b. What would happen to the market price of the debentures if the current yield rises to
i. 16% and ii. Drops to 12%?
Kd = I /SV  SV = I/Kd
Interest = 8% of Rs. 100 = Rs. 8
P0 = I /Kd = 8 / 0.10 = Rs. 80
P0 = I / K = 8 / 0.16 = 50
P0 = I / K = 8 / 0.12 = Rs. 66.67

If a 5-year debenture of Rs. 100 of a firm can be sold for a net price of
Rs. 96.5, the coupon rate of interest is 14% p.a. The debenture will be
redeemed are 5% premium on maturity, the firms tax rate is 40%.
Compute the after-tax cost of debenture.
Interest = 14% of Rs. 100 = Rs.14
Discount = 100 – 96.5 = Rs. 3.5
Premium on maturity = Rs.100 *5% = Rs. 5
MV = 100+ 5 = 105
SV = 96.5
Tax rate = 40%
Kd = 14 (1 – 0.40) + (3.5+5) / 5 = 8.4 + 1.7 = 0.10024 = 10.02%
(105 + 96.5) / 2 100.75