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 investor’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%