Cost of Debt
Cost of debt is the interest rate that the organization pays for the debts it have. The debts includes loan, bonds etc. The cost of debt is calculated both before tax calculation as well as after tax calculation this is called cost of tax before tax and cost of debt after tax. The cost of debt calculated after tax is given more preference by the investor whereas the cost of debt calculated before tax is given more preference by the firm.
The investor can identify how much risk the organization is taking, because higher the debt rate higher is the risk. If the debt rate is high the organization has to pay a higher amount for debt from profit, therefore there is higher cash out flow.
From an organization point of view the debt rate can be used to get tax exemption, thus organization uses this debt rate to get tax exemption. The organization can use cost of debt to get the best interest rate that is available for its financial needs. The organization can also make decision on whether to continue with the existing fund raising method or should it have to change the method completely. The organization can also make decision whether to continue with the current creditor or find new one.
Organization must take care that cost of debt does not go beyond certain level; it is not good for business and improving investor confidence as well. It is therefore the duty of the organization to keep the cost of debt as low as possible.
The formula used for calculating cost of debt is
Cost of Debt (before calculation of tax) = (C + (M-N)/n) / (M + N) / 2
Where C is the money returned, M is the maturity value, n is the number of years, N is the net proceeds issue.
Another formula to calculate cost of debt
Cost of Debt (after calculation of tax) = (I (1-t) +(R-S) /n) / (R+S) /2
Where R is the realizable value, S is the net proceeds issue, n is no of years, and tax rate.
Thus the cost of debt before taxing and after taxing are useful for the organization and the investor respectively to find the exact source of funds raising and to determine the risk in investing in the particular stock respectively.