A Company may raise debt in various ways. It may borrow funds from financial institutions or public either in form of public deposits or debentures for a specified period of time at certain rate of interest. A debenture or bond may be issued at per or at discount or premium.
(a) Debt issued at Par:-
The before tax cost of debt is rate of return required by lenders. It is easy to compute before tax cost of debt issued & to be redemed at par, it is simply equal to contractual interest. For example, a company decides to sell a new issue of 1 years 15% bond of Rs 100 Each at par. If company realises full face value of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity, the before tax cost of debt will simply be equal to rate of interest of 15%.
Kd= I= INT
KD= before-tax cost of debt.
I = coupon rate of interest.
B = Issue price of debt.
INT = amt. of interest.
(B) Debt issued at Discount or Premium:-
Bo = _________ + _________
t=1 (1+kd)t (1+ kd)n
Bn= repayment of debt on maturity and other variable as defined earlier. This equation is used to find out whether cost of debt issued at par or discount or premium.
i.e. Bo= f or Bo>f or Bo
The interest paid on debt is tax deductible. The higher the interest charges, the lower will be amount of tax payable by the firms. This implies that the government indirectly pays a part of lender’s required rate of return. As a result the interest tax shield, after tax cost of debt to the firm will be substantially less than investor’s required rate of return. The before tax cost of debt, kd should therefore, be adjusted for tax effect as follows.
After-tax cost of debt = kd (I-T)
Where T= Corporate tax rate.