For businesses, debt is a common way to raise funds, but it comes at a cost. The cost of debt is essentially the rate a company pays to borrow money.
In this session, we’ll break down everything you need to know about the cost of debt, including its calculation, significance, and nuances. By the end, you’ll feel confident tackling any related question in your UGC NET exam. So, let’s get started!
What is the Cost of Debt?
The cost of debt is the effective interest rate a company pays on its borrowed funds. It represents the compensation creditors require for lending their money.
For the borrowing company, this is a key component of the Weighted Average Cost of Capital (WACC), influencing its investment decisions and financial planning.
Why is the Cost of Debt Important?
- Decision Making: Helps assess whether debt financing is cheaper than equity.
- Investment Appraisal: Used in WACC to determine project viability.
- Creditworthiness: Reflects the firm’s ability to manage and repay debt.
Formula for Cost of Debt (Kd)
The cost of debt can be calculated in two scenarios:
1. Before-Tax Cost of Debt
Where:
- = Before-tax cost of debt
- Interest Expense = Annual interest payment
- Net Proceeds = Issue price minus issuance costs
2. After-Tax Cost of Debt
Since interest payments are tax-deductible, the actual cost of debt to a company is lower.
Key Concepts in Cost of Debt
1. Tax Shield
The tax-deductibility of interest provides a significant advantage to companies using debt financing.
2. Net Proceeds
Always adjust for issuance costs like underwriting fees, legal fees, etc. These reduce the effective funds raised.
Example 1: Basic Calculation
A company issues bonds with the following details:
- Face value = ₹1,00,000
- Coupon rate = 10%
- Issuance cost = ₹2,000
- Tax rate = 30%
Step 1: Calculate Before-Tax Cost of Debt
Step 2: Calculate After-Tax Cost of Debt
Thus, the after-tax cost of debt is 7.14%.
Types of Debt Instruments
- Bonds/Debentures: Long-term debt with fixed interest payments.
- Loans: Borrowed funds from banks or financial institutions.
- Convertible Debt: Can be converted into equity shares.
Factors Affecting Cost of Debt
| Factor | Impact on Cost of Debt |
|---|---|
| Creditworthiness | Higher credit rating → Lower cost of debt |
| Market Conditions | Higher interest rates → Higher cost of debt |
| Issuance Costs | Higher costs → Lower net proceeds → Higher |
| Type of Debt | Secured debt → Lower ; Unsecured → Higher |
Example 2: Redeemable Debt
When debt is redeemable, the cost of debt calculation considers the repayment of principal.
Example:
A company issues debentures:
- Issue price = ₹1,000
- Redemption price = ₹1,100
- Annual interest = ₹100
- Maturity = 5 years
Thus, the cost of redeemable debt is 11.43%.
Cost of Debt vs. Cost of Equity
| Feature | Cost of Debt | Cost of Equity |
|---|---|---|
| Nature | Fixed interest payments | Variable dividends |
| Tax Benefit | Interest is tax-deductible | Dividends are not tax-deductible |
| Risk | Lower risk for lenders | Higher risk for equity investors |
Tax Shield Impact
(Tax Shield reduces the effective cost of debt)
| Tax Rate | Before-Tax | After-Tax |
|---|---|---|
| 0% | 10% | 10% |
| 20% | 10% | 8% |
| 30% | 10% | 7% |
| 40% | 10% | 6% |
Exam Tips for UGC NET Aspirants
- Memorize Formulas: Be thorough with both basic and redeemable formulas.
- Understand Tax Shield: It’s a frequently asked concept.
- Practice Numericals: Focus on scenarios with issuance costs and redeemable debt.
- Compare with Equity: Know the advantages and disadvantages.