Cost of Debt
The cost of debentures and Long-term. Loan i.e., cost of debt-is the present effective interest for long-term debt, the interest payment must be adjusted to compensate for the fact that interest is deductible for tax purpose.
Mathematically, the explicit cost of debt can be derived from the above equation by solving for that discount rate K. Which regulates the net proceeds of the debt with the present value of interest plus principle payments, and then adjusting the cost of debt and debentures is contractual interest rate (adjusted) to net amount received, rather than face value adjusted further for tax liability or the company. If we denote the after tax cost of debt by , it can be approximated by.
K1= R.(I –t)
Where R is the contractual rate of interest or k is formula (i) and t is the marginal tax. rate.
To illustrate, if a company were able to contract debt with a 10% coupon rate and realize net proceeds after under writing or other costs of $930 for each $1,000 face value R would be 10.20% (10% × 100/980). If the corporation income tax were 50%
K1= 10.20 (1 – 50) = 5.10 percent.
In case there were not other cost of contracting debt the cost of debt would be 5% [10(1-50)]
It is, however to be noted that the 5 or 1 percent after tax cost represents the marginal, or incremental, cost of additional debt. It does not represent the cost of debt already employed in business. Secondly, it is implied that the company is profitable and so paying income tax-that is earning before the interest and taxes. (EBIT) is equal to or more the interest charges. If EBIT is less or negative, the tax shield does not apply and the actual cost of debt is before tax cost (i.e., Ki = R) Thirdly, the explicit cost of another sources having the same rate (K) but where financial charges are not deductable for tax purposes.
For determining the real cost of debt. it is necessary to consider not only contractual costs but also the imputed of implicit costs. The cost but also the imputed or implicit costs. The cost of debt finance rises above the contractual rate of interest as more debt finance is used, because (a) actual rate of interest will rise and (b) the total debt cost should include not only R but also an additional hidden cost that can be imputed from the decile in the rate () at which earnings on equity shares are capitalized (due to increasing financing risk) as we have seen in an earlier lesson on financial leverage or trading on equity.