The before-tax cost of debt is the rate of return required by lenders. It is easy to compute before-tax cost of debt issued and to be redeemed at par; it is simply equal to the contractual or coupon rate of interest. For example, a company decides to sell a new issue of 7 – year 15 per cent bonds of Rs 100 each at par. If the company realizes the full face value of Rs 100 bond and will pay Rs 100 principal to bondholders at maturity, the before-tax cost of debt will simply be equal to the coupon rate of interest of 15 per cent.
Thus:
Kdi = Interest / Bo
Where Kd is the before-tax cost of debt, i is the coupon rate of interest, Bo is the issue price of the debt and in Equation (1) it is assumed to be equal to the face value (F), and INT is the amount of interest. The amount of interest payable to the lender is always equal to:
Interest = Face value of debt x Coupon interest rate
INT=Fi
The before-tax cost of bond in the example is Rs15
Kd -Rs-l00- 0.15 or 15%
We could arrive at same results as above by using the formula for the internal rate of return: cash outflow are Rs 15 interest per year for 7 years and Rs 100 at the end of seventh year in exchange for Rs 100 now. Clearly, the before-tax cost of bond is the rate, which the investment should yield to meet the outflows to bondholders.
