Skip to main content

Cost of debt

1. Introduction

Companies raise debt through various channels, including financial institutions, public deposits, and debentures (bonds). The interest rate and the conditions of issue (par, discount, or premium) directly affect the cost of this debt. This document explains the process of calculating the cost of debt.

2. Key Concepts

  • Cost of Debt: The effective rate a company pays on its borrowings, considering tax benefits.
  • Coupon Rate: The contractual rate of interest specified on a debt instrument.
  • Par Value: The face value of a debt instrument.
  • Discount: When a debt instrument is issued for less than its face value.
  • Premium: When a debt instrument is issued for more than its face value.
  • EBIT: Earnings Before Interest and Tax
  • Tax Shield: Reduction in taxes due to the deductibility of interest payments from taxable income.

3. Debt Issued at Par

3.1. Definition

Debt issued at par means that the company issues debt at its face value, equal to the principal amount that will be repaid at maturity.

3.2. Calculation

  1. Before-tax cost of debt (kd):

    • Equal to the contractual (coupon) rate of interest.
        kd = i = INT / B0
    • i is the coupon rate of interest.
    • B0 is the issue price of the bond and is assumed to be equal to the face value, F.
    • INT is the amount of interest.

  2. After-tax cost of debt:

    • The explicit interest rate adjusted for the tax liability. 
      After-tax cost of debt = kd * (1 – T)
      • T is the corporate tax rate.

3.3. Example: Debt Issued at Par

A company issues 8% debentures and the tax rate is 50%. The after-tax cost of debt is calculated as follows:

kd = (1-50%) * 8 = (1-0.5) * 8 = 4%

3.4. The Tax Advantage of Debt

  • Interest is treated as an expense while calculating taxable income, which reduces the amount of tax payable.
  • The tax-adjusted interest rate is used only when Earnings/Profits Before Interest and Tax (EBIT) is equal to or more than the interest expenses.

4. Debt Issued at a Discount or Premium

4.1. Definition

  • Discount: Debt issued for less than its face value.
  • Premium: Debt issued for more than its face value.

4.2. Impact

The cost of debt is not equal to the coupon rate of interest when bonds or debentures are issued at a premium or a discount. Also, the amortization of discounts or premiums may also affect tax calculations.

4.3. Calculation

In these cases, the cost of debt must be calculated by discounting future cash flows, or with the following formula:

kd = (I (1-T) + (RV - SV) / Nm) / ((RV+SV)/2)

 where
  • kd= Cost of debt
  • I = Annual interest payment
  • T= Corporate tax rate
  • RV= Redeemable value of debenture
  • SV= Sales proceeds of the debenture
  • Nm= Years to maturity

4.4. Example 1: Discount and Premium

A company issues 10% Debentures for Rs. 200,000. The rate of tax is 55%. Calculate the cost of debt if the debentures are issued at:

(i) Par:

  • kd = (20,000 / 200,000) * (1 - 0.55) = 4.5%

(ii) 10% Discount:

  • kd = (20,000 / 180,000) * (1 - 0.55) = 5%

(iii) 10% Premium:

  • kd = (20,000 / 220,000) * (1 - 0.55) = 4.1%

4.5. Example 2: Redeemable Debt

A company raises Rs 90,000 by issuing 1,000 10% debentures of Rs 100 each at a 10% discount, repayable at par after 10 years. The tax rate is 50%. Calculate the cost of debt capital to the firm.

Cost of debt = [10 *(1 - 0.5) + (100 - 90)/10] / [(100 + 90) / 2 ] = 0.1105 or 11.05%

5. Cost of Redeemable Debt

5.1. Definition

Redeemable debt instruments have a fixed maturity date at which the principal amount is repaid to the investor, and are also referred to as term debt.

5.2. Formula

The effective cost of debt before tax can be calculated as follows:

CI0 = [∑(COIt / (1 + kd)^t] + [ RV / (1+kd)^n]

Where:

  • CI0: Net cash proceeds from the debt issuance.
  • COIt : Cash outflows from interest payments adjusted for tax.
  • RV : Repayment amount at the time of maturity.
  • kd: Effective cost of debt.
  • n: number of periods for the cash flows.

5.3. Example: 10% Debentures

A company issues 10,000 10% debentures at Rs 10 each, realizing Rs 95,000 after a 5% commission to brokers. The debentures are redeemed after 10 years. Calculate the effective cost of debt before tax.

The effective cost can be calculated by trial and error or by solving for kd using the above formula.

6. Tax Adjustment

  • Interest Tax Shield: Interest payments on debt are tax-deductible.
  • After-Tax Cost: The before-tax cost of debt should be adjusted for the tax effect.

After-tax cost of debt = kd (1 - T)

Where:

  • kd: Before-tax cost of debt.
  • T: Corporate tax rate.

6.1. When is there no tax advantage on debt?

  • The tax benefit is only available if the company is profitable and pays taxes.
  • If a company suffers losses, there is no tax to adjust, and the cost of debt is the before-tax cost (ki).

6.2. Importance of After Tax Cost

  • In calculating the average cost of capital, the after-tax cost of debt must be used instead of the before-tax cost of debt.

7. Multiple Debt Issues

In practice, companies often have multiple debt issues with different interest rates. The overall cost of debt is calculated by computing the weighted average cost of all debt issues.

8. Conclusion

Calculating the cost of debt is a crucial step in financial management. It is the rate at which a company is borrowing money. It depends on the terms of the debt instruments, tax rates, and if the debt was issued at par, premium or at a discount. Understanding these factors is essential for effective capital budgeting and financial planning.

No Comments
Back to top