Cost of Debt

Generally, cost of debt capital refers to the total cost or the rate of interest paid by an organization in raising debt capital. However, in a real situation, total interest paid for raising debt capital is not considered as cost of debt because the total interest is treated as an expense and deducted from tax.

This reduces the tax liability of an organization. Therefore, to calculate the cost of debt, the organization needs to make some adjustments. Let us understand the calculation of cost of debt with the help of an example.

Suppose an organization raised debt capital of Rs. 10000 and paid 10% interest on it. The organization is paying corporation tax at the rate of 50%. In this ca.se, the total 10% of interest rate would not be deducted from tax and the deduction would be 50% of 10%.

Therefore, the cost of debt would be only 5%. While calculating cost of debt capital, discount allowed, underwriting commission, and cost of advertisement are also considered. These expenses are added to the amount of interest paid, which is considered as total cost of debt capital.

For example, when an organization increases its proportion of debt capital more than the optimum level, then it increases its risk factor. Therefore, the investors feel insecure and their expectations of EPS start increasing, which is the hidden cost related to debt capital.

Formulae to calculate cost of debt are as follows

1. When the debt is issued at par

K_D = [(1-T)*R]*100

Where,

K_D = Cost of debt

T = Tax rate

R = Rate of interest on debt capital

K_D = Cost of debt capital

2. Debt issued at premium or discount when debt is irredeemable

K_D = [1/NP*(1-T)* 100]

Where,

NP = Net proceeds of debt

3. Cost of redeemable debt:

K_D = [{I (1-T) -H (P-NP/N) * (1- T)}/ (P -H NP/2)] * 100

Where,

N = Numbers of years of maturity

P = Redeemable value of debt

For example, an organization issued 10% debentures of the face value of Rs. 100 redeemable at par after 20 years.

Assuming 50% tax rate and 5% floatation cost, calculate cost of debt in the following conditions:

1. When debentures are issued at par
2. When debentures are issued at 10% discount
3. When debentures are issued at 10% premium

Solution

The solution is given as follows:

Cost of redeemable debt = [{I (1-T) + (P- NP/N) (1- T)}/ (P + NP/2)] * 100

1. When debentures are issued at par

K_D = [{10(1 – 0.50) + (100 – 95/20) (1 – 0.50)}/ (100 + 95/2)] *100

= 5.25%

2. When debentures are issued at 10% discount

K_D = [{10(1 – 0.50) + (100 – 85/20) (1 – 0.50)}/ (100 + 85/2)] *100

= 5.81%

3. When debenture is issued at 10% premium

K_D = [{10(1 – 0.50) + (100 – 110/20) (1 – 0.50)}/ (100 + 110/2)] *100

= 4.52%