COST OF DEBT.pptx

Cost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis, which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.

1. UNIVERSITY OF JAMMU NAME : DHEERAJ SINGH ANDOTRA ROLL NO. : 0002MBIB21 SUB. TITTLE : Financial Management SUB. CODE : PSIBTC SUBMITTED TO : Mr. Bhanu Pratap Singh

2. COST OF DEBT Cost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the  discounted valuation analysis , which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders. The cost of debt may be determined before tax or after tax.

3. How the Cost of Debt Works Debt is one part of a company’s capital structure, which also includes equity. Capital structure deals with how a firm finances its overall operations and growth through different sources of funds, which may include debt such as bonds or loans. The cost of debt measure is helpful in understanding the overall rate being paid by a company to use these types of  debt financing . The measure can also give investors an idea of the company’s risk level compared to others because riskier companies generally have a higher cost of debt.

4. Cost of Debt Formula (Kd)

5. For example, if a firm has availed a long term loan of $100 at a 4% interest rate, p.a , and a $200 bond at 5% interest rate p.a. Cost of debt of the firm before tax is calculated as follows: (4%*100+5%*200)/(100+200) *100, i.e 4.6%. Assuming an effective tax rate of 30%, after-tax cost of debt works out to 4.6% * (1-30%)= 3.26%. Example #1

6. Advantages An optimum mix of debt and equity determines the overall savings to the firm. In the above example, if the bonds of $100 were utilized in investments that would generate return more than 4%, then the firm has generated profits from the funds availed. It is an effective indicator of the adjusted rate paid by the firms and thus aids in making debt/equity funding decisions. Comparing the cost of debt to the expected growth in income resulting from the  capital investment  would provide an accurate picture of the overall returns from the funding activity.

7. Disadvantages The firm is obligated to pay back the principal borrowed along with interest. Failure to pay back debt obligations results in a levy of penal interest on debts . The firm may also be required to  earmark  cash/FD’s against such payment obligations, which would impact free cash flows available for daily operations. Non-payment of debt obligations would adversely affect the overall  creditworthiness  of the firm.

8. Limitations Calculations do not factor in other charges incurred for debt financing, such as credit underwriting charges, fees, etc. The formula assumes no change in the capital structure of the firm during the period under review. To understand the overall rate of return to the debt holders, interest expenses on creditors and current liabilities should also be considered. An increase in the cost of debt of a firm is an indicator of an increase in riskiness associated with its operations. The higher the cost of debt, the riskier the firm.

9. THANKS