Question 3 OR (b)
Why debt costs less than equity; methods of calculating the cost of debt
7 marks
- Time to write
- About 14 minutes
From an older CBCS paper
Question
Question 3 OR (b) · 7 marksExplain: "The cost of debt is generally lower than that of equity." Also, explain the various methods of calculating the cost of debt.
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainTie the answer to the quoted statement: say what it means first, and come back to it at the end.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Why debt costs less 3 marks 5 min
- 2 Methods of calculating the cost of debt 3 marks 5 min
- 3 Example 1 mark 2 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 3 in a line or two.
Try it first. About 14 minutes for 7 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Why debt usually costs a firm less than equity
- Tax deductibility of interest. Interest is allowed as a deductible expense in computing tax, so the effective cost of debt is reduced to I(1 − t); preference dividend is not tax deductible and gives no tax shield, and equity dividends are an appropriation of profit, not an allowable expense.
- Lower risk to the lender. Interest is a fixed, contractual payment due whether or not the firm earns a profit; lenders are repaid at maturity, rank before shareholders in liquidation and are often secured. Equity holders bear the residual risk and demand a premium for it.
- Lower issue costs, no dilution of control: no new shares are issued; earnings per share rise only when the funds earn more than the cost of the debt.
Debt is cheaper only within limits: heavy borrowing raises financial risk, and with it the costs of further debt and of equity.
Methods of calculating the cost of debt
| Kind of debt | Formula | Notes |
|---|---|---|
| Issued at par (before tax) | Kdb = I ÷ P | I = annual interest, P = principal |
| Issued at a premium or discount | Kdb = I ÷ NP | NP = net proceeds after issue costs |
| After tax | Kd = I(1 − t) ÷ NP | t = tax rate; the cost used in the WACC |
| Redeemable debt | Kd = [I(1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2] | RV = redemption value, n = years to redemption (approximation method) |
| Existing debt, market basis | Kd = I(1 − t) ÷ market price | For irredeemable debt quoted in the market |
Example: 10% debentures of ₹100 issued at ₹95, tax 30%, irredeemable: Kd = 10 × 0.70 ÷ 95 = 7.37%. If redeemable at par after 5 years: Kd = [7 + (100 − 95) ÷ 5] ÷ [(100 + 95) ÷ 2] = 8 ÷ 97.5 = 8.21%.
Where the 7 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Why debt costs less | 3 |
| 2 | Methods of calculating the cost of debt | 3 |
| 3 | Example | 1 |
| Total | 7 |
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