Cost of debt formula and how to calculate cost of debt. This is based on the interest rate investors require on debt issues, adjusted for taxes.
This is so because interest payments on debts are tax deductible.
What is cost of debt
The cost of debt can be expressed as the the rate of return that creates the periodic net cash outflow for interest payment and principal repayment with the next proceeds from the issue.
Generally, the cost of debt is calculated from the yield to maturity of bonds.
The yield to maturity of is the rate of return earned on bond if it is purchased at a given price and held to the maturity.
Cost of debt is a very much important metric in an organisation or a business.
Internally, it’s a useful way to see how much of an impact external finance has on one’s business.
It’s easy to lose track of exactly how much you’re leveraging loans, bonds and other means to grow an organisation or a business.
One of the ways to improve a business or company cost of debt is through refinancing.
This is an active debt obligation, which will largely depend on an organisation payment history.
Lenders will usually be more open to refinancing if an organization has been making payments on time or early.
Another option is to shop around and refinance existing loans with other lenders.
The cost of debt formula
The cost of debt formula is calculated as thus;
Ytm = rp + (P – Mv)/n /(MV + P)/2
Where r = Periodic interest payment
Mv = Market value of bond
P = Bonds issue price
L = Number of years to maturity
Ytm = Yield to maturity
Note that the (P – MV) represents the discount for premium on the bond. The model does not consider compounding effects.
It is monthly used when flotation costs are involved.
How to calculate cost of debt
Let’s go over on how to calculate cost of debt.
Example Assuming Pinkos plc 21 percent (21%) floating rate redeemable debenture stock issued at N1000, nominal value on 1995 and due for retirement in December 2006.
The stock has a market price of N110.00 in 2002 December. What is the yield to maturity.
Ytm = . 21 (1000) + (1000 – 1100)/4 x 100 / (1000 – 1100)/2
This equals 210 – 25 / 1050 = 17.6 percent respectively.
It should be noted that as the period to the maturity reduces, the yield to maturity reduces.
This is given that the market price of the stock is fairly constant, although this may not be the case in reality.
For example, assuming Pinko plc debenture stock above a market price of N1300 in 2000, the yield to maturity would become;
-21 (1000) + (1000 – the 1300)2 / (1000 + 1300)/2
This equals 210 – 150 / 1150 = 5.2%
This is how to calculate cost of debt, next is after tax cost of debt formula and also how to calculate after tax cost of debt.
What is after tax cost of debt
This occurs after the yield to maturity approximates the before tax cost of debt.
However, there is the need to state specific cost of debt financing on an after tax basis.
Why is this so?
We are aware that the interest on long term debt is tax deductible.
This imply that interest debt reduces the firm’s taxable income by the amount of deductible interest.
In view of the above, after tax cost of debt formula is (ka) = kd (l – t). Where;
kd = before tax cost of debt
t = Tax rate
Example Pius plc has the following capital mix
|Source of capital||(1)||(2)||(1) x (2) = (3)|
|Long term debt||. 30||8%||. 024|
|Preferred stock||. 20||12%||. 025|
|Common stock equity||. 50||15%||. 075|
Weighted average cost of capital formula = 12.4%
Assuming the tax rate is 30 percent, the after tax cost of debt = 12.4 (1 – .20) = (.70) = 8.68%
That’s how to calculate after tax cost of debt.
The weighted marginal cost of capital
The weighted marginal cost of capital (WMCC) is simply calculated when a firms weighted average cost of capital, associated with its next amount of total new financing.
The weighted avarage cost of capital could vary at each point in time, depending on the volume of funds the firm plan to raise.
This is because as the volume of funds increase, the cost on the various types of financing increases.
This ultimately raise a firm weighted average cost of capital.
The weighted marginal cost of capital schedule could be said to be a schedule or graph, relating the firm’s weighted cost of capital to the level of total new financing undertaken by the firm.
As the new level of jew financing increases, the weighted average cost of capital also increases.
The increased cost of funds is as a result of the increased interests or dividends paid as a compensation for the additional risks they carry on the increased volume of funds.
Also, the weighted average cost of capital will rise as soon as the firm introduces additional common stock, which is more expensive.
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This is the case with new issues made by a company in preference to retained earnings, which may be less expensive.