Concept Of Cost Of Debt
The cost of obtaining and using interest paying liabilities is known as cost of debt. Generally, companies borrow debt through the issuance of debenture and bonds. Thus, the cost of debt is the cost associated with the interest payment and other cost of issuing the debenture and bonds.
It is important to note that the cost of debt is computed on after tax basis because interest is a tax deductible expense. In other words, the company can deduct the interest from income while calculating tax. Payment of interest saves tax which is called tax shield or tax benefit. The amount of such tax is equal to interest X tax rate. Thus the net cost of debt is computed on the basis of interest X (1- tax rate. This rule does not apply in case of ordinary and preference shares.
Essential Features Of Debt
Before computing the cost of debt, it is essential to understand the essential features of debt which are as follows:
1. Face Value/Par Value (FV)
The value mentioned in the debenture certificate is known as par value or face value of the debenture. The debenture can be issued at any price, however, the amount of interest is calculated on the basis of face value. In brief, the principal per debenture is called face value or par value.
2.Coupon Rate (R)
The interest rate stated in the debenture certificate is known as coupon rate. Coupon rate is the simple interest rate and the amount of interest is determined on the basis of the coupon rate not on the basis of the prevailing market interest rate.
3.Maturity Period (M)
The time period of the loan or life of the debenture is known as maturity period of the debt. For example, if a company issued debentures on Jan. 1, 2011 and these debentures are repayable on Dec. 31, 2021, then the total time period from the date of issue to final due date is called maturity period which is 10 years.
4. Call Provision
Call provision is the clause stated in the debt contract under which the company can refund the amount of debt before the maturity period. The time at which the amount is refunded is called call period and the amount refunded is called call price.
5. Net Proceed (NP)
The amount received by the company issuing a debenture after deducting all issuing expenses (except interest) is called net proceed. Net proceed is computed on the basis of the following factors:
i. Face value of the debenture (total or per debenture)
ii. Discount or premium on issue
iii. Issuing cost or flotation cost
On the basis of above information, net proceed can be computed as follows:
Net proceed (NP) = Gross selling price - Flotation cost
= Face value + Premium (or - discount) - Flotation cost
Types Of Cost Of Debts
1. Cost Of Perpetual Debt
The debt on which maturity period is not given is called perpetual debt. The cost of such bond is computed as below:
Condition 1: when the bond is selling at face value:
Cost of debt (Kdt) = Interest rate X ( 1- Tax rate) = Kb(1-t)
Condition 2: when the bond is selling below or above the face value:
Kdt = 1/NP X (1-t)
2. Cost Of Non-perpetual Debt Or Debt With Maturity Period
When the life or maturity period of debt is given, such debt is known as Non-perpetual debt or debt with maturity period.
3. Cost Of Debt Issued On Redeemable Condition
In most cases, the face value of debt is refunded at the end of maturity period. However some bonds and debentures are repayable at premium or discount. In such condition, the amount of interest is computed on the basis of face value and the cost is computed on the basis of redemption. Redemption value is computed as below:
i. When bonds/debentures are repayable at premium:
Repayable value = Face value + premium on redemption
ii. When bonds/debentures are repayable or redeemable at discount:
Repayable value = Face value - Discount on redemption
4. Cost Of Callable Debt
The debt, which is refunded by the company before the maturity period is called callable debt. The time at which the amount is refunded is called call period (NC) and the amount refunded is called call price (CP).
