Cost of debt
(Kd(1-t)).
Definition of Cost of debt
The component of a firm's Weighted average cost of capital which relates to the servicing of the firm's providers of debt capital.
The calculation of the current market cost of debt is based on the Market Yield to maturity of any debt currently in issue.
This will normally be different from the interest rate on the debt, which is not the relevant measure for investment decision making purposes.
Simple calculation of corporate tax relief
The calculation should also take account of related corporate tax relief on the debt servicing costs.
Hence the '( 1 - t )' term in Kd( 1 - t ).
Cost of debt is often denoted more simply as 'Kd'. However this is not best practice, because it may be ambiguous whether the 'Kd' figure is stated before or after the related tax relief.
Example
Say the relevant cost of debt is 5% per annum before tax relief, all debt servicing costs are fully tax relieved at 28%, and there are no timing differences between paying the debt servicing costs and enjoying the related tax relief,
Kd( 1 - t ):
= 5 x ( 1 - 0.28 )
= 3.6%.
More strictly, the related tax relief should be factored into the net cost of debt calculation by taking account of any timing differences between the debt servicing cash outflows and the related tax savings.
