AFMP4
Syllabus B3cd. The Cost of CapitalCost of debt

# Irredeemable, preference shares and Bank loans 2 / 4

### Irredeemable Debt

The company just pays back the interest (NOT the capital)

So the MV should just be all the expected interest discounted at the investorâ€™s required rate of return.

The Cost of Debt for this therefore is:

Annual Interest (after tax) / Market Value

#### Illustration

5% Irredeemable Debentures
MV is \$90

Tax is 20%.

What is the post-tax cost of debt of these irredeemable debentures?

• Solution

The formula to calculate the post-tax cost of debt is:

I * (1-T) / Market Value x 100%, where I is the Annual interest and T is the tax rate.

(5 x 80%) / 90 x 100% = 4.4%

### Preference Shares

Treat the same as irredeemable debt except that the dividend payments are never tax deductible

The Cost of Debt for this therefore is:

Annual Dividend / Market Value

#### Illustration

8% Preference Shares.
MV 1.20.

What is the cost of debt for these?

• Solution

The formula to calculate the post-tax cost of debt is:

Annual Dividend / Market Value

8 / 120 x = 6.67%

### Bank Loans

The cost of debt is simply the interest charged.

Do not forget to adjust for tax though if applicable.

#### Illustration

10% Bank Loan.

Tax 30%.

What is the cost of debt?

7%

• Solution

10 x 70% = 7%