Cost of Debt Concept
Cost of debt is normally lower than cost of equity because
debt involves lower risk. Traded debt is always quoted at nominal value of $
100 and interest is always paid on the nominal value known as coupon rate. The
coupon rate is not cost debt. The
value of debt may rise or fall but interest will always be charged on the
nominal value.
Types of debt issued by companies
The
following debt are issued by the companies
1. Debentures
2. Loan
3. Bonds
What is irredeemable debt?
The debt which will never be paid back is known as
irredeemable debt. This is only a theoretical concept because in real life all
debts are redeemable i.e. to be paid back on maturity. Cost of debt of in case
of irredeemable debt is calculated by following formula.
Cost of Debt = Io ( 1-T)/Po
Io= Interest rate
T= Tax Rate
Po= Market value of debt
(Ex interest Price)
Cost of Irredeemable Debt Example
ABC company
debt is quoted at market @ 140. The nominal rate is 15% and tax rate in the
country is 30%.
Solution
In this example the nominal price of debt is missing and
therefore it is assumed that nominal price is $ 100. The nominal price is
required to calculate the interest rate. It is also assumed that market price
given in the example is ex interest.
|
Interest Rate
|
15%
|
|
Market Price ex interest
|
140
|
|
Tax Rate
|
30%
|
|
Cost
of Debt
|
[15
(1-30%)]/140 = 7.5%
|
What are redeemable Debt
The
redeemable debt is paid on maturity. There are three types of redeemable debts
1. Redeemable at par – at nominal price
(issue price)
2. Redeemable at premium – at price
higher than issue price (nominal price)
3. Redeemable at discount – at price
lower than nominal value (issue price)
How cost of redeemable debt is
calculated
The cost of redeemable debt is calculated by internal rate of
return formula. There are three types of cash flow involves in the redeemable
debt i.e. market value of debt, interest payment and redemption on maturity.
|
ABC & Co
Qouted
|
102
|
|
Coupon Rate
|
10%
|
|
Tax rate on
companies
|
30%
|
|
Maturity
|
5 years
|
Solution
|
|
|
|
5%
|
PV @ 5%
|
10%
|
PV @ 10
|
|
|
Market Value
|
102
|
1
|
102
|
1
|
102
|
|
|
Interest (100x
10%x 70%)
|
(7)
|
4.329
|
(30.30)
|
3.791
|
(26.53)
|
|
|
Redemption Value
|
(100)
|
.784
|
(78.40)
|
.621
|
(62.1)
|
|
|
|
|
|
(6.7)
|
|
13.37
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Formula = L +(Nl/Nh-Nl)x (H-L)
= 5% + (6.7/20.07)(5%)
=.05+.323(.05)
=6.65%
