The document discusses the cost of debt, which is the expected rate of return for debt holders calculated as the effective interest rate on a firm's liabilities. It is used to discount future cash flows in valuation analysis. The cost of debt can be determined before or after taxes. It is helpful for understanding the rate paid by a company using debt financing and its relative risk level compared to other companies. The document provides an example cost of debt calculation and discusses advantages like overall savings from an optimal debt-equity mix, and disadvantages like obligation to repay principal and interest which could impact cash flows. Limitations are that other debt financing costs are not factored in and the capital structure is assumed unchanged.

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