CMA Study Group

Cost of Debt Calculation

  • 1.  Cost of Debt Calculation

    Posted 13 days ago
    I hope all of you are doing well, 

    I need your help to calculate the cost of debt, 

    -  Some years ago the firm issued 10,000 bonds, each with a face value of $1,000 and paying an annual coupon rate of 9.2%. These bonds are now trading at $1,040 per bond. A coupon payment on these bonds was made yesterday and the bonds mature next year.

    Effective tax rate 30%.

    Ahmed Ouda

    Accountant.





  • 2.  RE: Cost of Debt Calculation

    Posted 12 days ago
    Hi,

    Cost of debt uses coupon rate and the rate of tax as decision variables.

    Cost of debt = Rate of Interest * (1-Tax Rate)

    In this case = 9.2%*(1-30%)=6.44%

    (If we were to calculate the return on the investment made in debt security then the market value and face value factor shall be used.

    As you will receive the interest on the face value but the amount invested is more than the FV, it would result in lower realization)


    ------------------------------
    Harjjeet Gahla (ACS LLB DBF ADM)
    FInancial Controller / Accountant
    Calgary Alberta
    Canada
    ------------------------------



  • 3.  RE: Cost of Debt Calculation

    Posted 11 days ago
    Your answer is not correct.

    You must use the available information to calculate the YTM (effective interest rate).  Utilize this rate to calculate the after tax cost of debt.

    FV = 1000
    PV = -1040
    PMT = 92 (.092 x 1000)
    Per = 1

    The rate will calculate as 5%

    5% X (1-.30) = 3.5%



    ------------------------------
    Michael Henry
    Controller
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  • 4.  RE: Cost of Debt Calculation

    Posted 11 days ago
    Hi Michael,

    You are right in pointing it out. I only broached the topic and mentioned the possible impact of FV and MV on the cost in the brackets, but I did not complete the solution in my previous post to the group though I shared the full working with Ahmed. 

    The solution to this problem is attained by using the equation. The total expected return on this is FV and Int, which is discounted with the debt cost to arrive at the present value or the market price. 

    (FV+Int )/MV=(1000+92)/1040=5%

    Since the question did not ask for WACC, in my opinion, the answer should be 5%, and we should not consider the impact of tax unless required to do so.

    If a question asked for the after-tax cost of debt or the Weighted average cost of capital, we should use the weights and the after-tax cost of each component to arrive at WACC.