A company may raise debt in a variety of ways. It may borrow funds from financial institutions or public either in the form of public deposit or debentures (bonds) for a specified period of time at a certain rate of interest.
A debenture or bond may be issued at par or at a discount or premium as compared to its face value. The contractual rate of interest or the coupon rate from that basis for calculating the cost of debt.
Debt issued at par
The before-tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost of debt issued and to be redeemed at par; It is simply equal to the contractual or coupan rate of interest.
For example, a company decides to sell a new issue of 7 years 15 percent bonds of Rs. 100 bonds and will pay Rs. two each at par. If the company realises to bond holders at maturity, the before-tax cost of debt will simply be equal to the rate of interest of 15 percent.
Kd= before-tax cost of debt
i= the coupan rate of interest
Bo= the issue price of the bond(debt)
INT= Amount of interest
The before tax cost of bond in the example
Kd = = 0.15 or 15%
Debt issued at discount and premium
When debt is issued at par and redeemed at par. This equation can be rewritten as follows to compute the before-tax cost of debt.
Bn= The repayment of debt on maturity
If the discount or premium is adjusted for computing taxes, following short-cut method can also be used to calculate the before-tax cost debt.
Cost of the existing debt
Sometime a firm may like to compute the current cost of the existing debt. In such a case the cost of debt should be approximate by the current market yield of the debt.
Firm has 11 percent debenture of Rs. 100000(rs.100 face value l) out standing at 31 December.19×1 matured on December 31. 19×6 ). If a new issue of debentures could be sold at net reliable price Rs.80 in the beginning of 19×2.
Tax adjustment in debt
The interest paid on debt is tax deductible. The higher the interest charges the lower will be the amount of tax payable by the firm. This implies that the government indirectly pays a part of the lender’s required rate of return. As a result of the interest tax shield, the after tax cost of debt to the firm will be substantially less than the investor required rate of return.
The before-tax cost of debt kd should therefore, be adjusted for the tax effect as follows.
After tax cost of debt
Kd(I-T), where T= the corporate tax
Kd(1-T)=0.1650(1-0.35)=0.1073 or 10.73%
It should be noted that the tax benefit of interest deductibility would be available only when the firm is profitable and is paying taxes.
An unprofitable firm is not required to pay any taxes. It would not gain any tax benefit associated with the payment of interest and it’s true cost of debt is the before-tax cost.
It is important to remember that in the calculation of the average cost of capital. The after-tax cost of debt must be used, not the before-tax cost of debt.