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 A bond or debenture is generally issued at a par value of Rs. 100 or Rs.1000 and interest is paid on face value
Interest rate
It is fixed and known to bondholders or debenture holders. Interest paid on a bond is tax deductible
Redemption value The value that a bondholder or debenture holder will get on maturity is called redemption or maturity value
Maturity
A bond or debenture is generally issued for a specified period of time. It s repaid on maturity
The price at which bond or debenture is currently traded in a stock exchange is called the market 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 DEBENTURES
VALUE OF BONDS
Cost of Irredeemable Debentures
1) Cost of Debentures
Cost of Redeemable Debentures
Bond Amortisation
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, debentures, t= tax rate NP= Net proceeds of
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}
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2) Valu of Bond It is r ti is u t r t s i i ut i u sist u it iz ti r h i r h r r t
a) Bond Amor ization rtiz r r Pri i is r i r r r th r th t turit h ri i is r i r r r th r th t turit I su h situ ti th ri i wi w with u ts i t r st wi ut th utst i u t h sh ws th wi u F r u r s rtiz r r Vb C1/ (1+Kd )1 + C2/ (1+Kd)2 + Cn/( 1+ Kd)n = Ct / (1+Kd )t
FORMUL s U ED 1 Before-t x ost of debt I kd ! 1000 N d n 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
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Pre erence Share
The cost of preference share capital is the di idend expected by its holders. Thou h payment of di idend 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= pr ferred 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 U ED: kp ! Dp Np
Where, Kp = cost of preferred equity Np = net proceeds from the sale of shares Dp = annual dollar dividend