Cost
of debt capital
The cost of debt capital is calculated as the discount rate
that equates the present value of post tax interest and
the principal repayments with the net proceeds on the debt
issue. Kd denotes the cost of debt capital.
n
I (I-T) Bn
B0 = S
----------
+ ------------
t =1
(1+kd) t (1+kd)
n
S
----------
+ ------------
t
=1 (1+kd)
t (1+kd)
n
Where
B0
= the issue price of the bond.
I =
the annual interest payable.
Bn
= the repayment of debt on maturity or redemption
price.
n
=
the maturity period of debt.
T =
tax rate applicable to the firm.
Interest
payment is a tax-deductible expense and brings tax-shield
of I x T. Therefore an interest payment of I in pre-tax
terms means a post tax payment of I (1-T).
For
a company, the higher the interest charges, the lower the
amount of tax payable by the company. An illustration will
clarify this point.
Consider
two companies X and Y:
|
|
Company
X
|
Company
Y
|
|
Earnings
before interest and taxes (EBIT)
|
100
|
100
|
|
Interest
(I)
|
-
|
40
|
|
Profit
before tax (PBT)
|
100
|
60
|
|
Tax
(T) 1
|
35
|
21
|
|
Profit
after tax (PAT)
|
65
|
39
|
1. Assuming an effective rate
of tax of 35 percent
A comparison of the two companies shows that an interest payment
of 40 in company Y results in a tax shield of 14 - that
is 40 multiplied by 0.35, the corporate tax rate.
The
important point to remember, while calculating the
average cost of capital, the post-tax cost of debt must
be used and not the pre-tax cost of debt.
Cost
of preference capital
Preference share carries a fixed rate of dividend. The
cost of redeemable preference capital is the value Kp in
the formula.
n
D Pn
P0 = S
-------------
+
---------------
t = 1 (1+kp)
t
(1+kp)n
Where
Kp is the cost of preference
share
D is
the dividend
P0
is the issue price of preference share.
Pn is the redemption
price
n is the maturity
period.
The
cost of irredeemable preference share is
Kp= D/P0
Preference
dividend is paid after the corporate taxes have been paid
and hence they do not save any taxes. The post-tax cost
of preference dividend is higher than the post-tax cost
of debt.
|
