Financial Management and Strategic Management · Cost of Capital

Cost of Debt: Debentures, Bonds and Term Loans for CA Inter

Updated 4 October 2026 · Fact-checked

Cost of debt is the return lenders require on debentures, bonds or loans, usually shown after tax. For irredeemable debt use Kd = I(1 − t) ÷ NP. For redeemable debt use [I(1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]. Always use net proceeds, not face value.

Understand Cost of Debt (Debentures, Bonds and Term Loans)

Cost of debt (Kd) is the rate a company must pay its lenders to keep the money. It is the discount rate at which the cash received from lenders equals the cash the company pays back (interest and repayment).

Start with the simplest case. If you borrow ₹100 and pay ₹10 interest every year forever, the cost is 10%. That is an irredeemable (perpetual) debenture. Real life adds three things: you may receive less than face value (issue at discount, or after issue costs), you may repay more than face value (redemption at premium), and you repay after a fixed number of years (redeemable debt).

So always work with net proceeds (NP). NP = issue price − issue costs (for a premium issue, add the premium). The company receives NP, but pays interest on face value and repays the redemption value (RV). The gap between RV and NP is an extra cost spread over the years, which is why the redeemable formula adds (RV − NP) ÷ n to the interest.

Interest is a tax-deductible expense, so the real cost to the company is lower. That is why we compute after-tax Kd by multiplying interest by (1 − t). In WACC, always use after-tax Kd. A term loan works the same way: its cost is the interest rate × (1 − t), adjusted for processing fees if the question gives them.

The YTM approach is the exact method. You find the rate that makes the present value of future after-tax interest and the redemption value equal to the net proceeds. The formulas above are close approximations that ICAI accepts when the question does not ask for YTM or IRR.

Key rules to remember

Net proceeds (NP): NP = Issue price − Issue costs (add premium if issued at premium; subtract discount if issued at discount); Use NP, not face value, whenever issue costs, discount or premium are given.
Irredeemable debt, before tax: Kd = I ÷ NP; I is the annual interest on face value (coupon rate × face value).
Irredeemable debt, after tax: Kd = I(1 − t) ÷ NP; t is the tax rate. Use this value in WACC.
Redeemable debt, before tax (approximation): Kd = [I + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; n is years to redemption. RV is the amount repaid, including any premium.
Redeemable debt, after tax (approximation): Kd = [I(1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; This is the usual ICAI form. Tax is applied to interest only. If the question says to compute before-tax Kd and then adjust, follow its instruction.
YTM (exact method): NP = Σ [I(1 − t) ÷ (1 + k)^t] + RV ÷ (1 + k)^n; Try two rates, get NPVs of opposite sign, then interpolate to find k.
Term loan: Kd (after tax) = Interest rate × (1 − t); If a processing fee is given, treat it as an issue cost and reduce the net amount received.

How to solve Cost of Debt (Debentures, Bonds and Term Loans) questions

Use this order for any cost of debt question. It stops you from mixing face value, net proceeds and redemption value.

1Read the data and write down face value, coupon rate, issue price, issue cost, redemption value, years to maturity and tax rate.
2Find the annual interest: I = coupon rate × face value (not issue price).
3Find net proceeds: issue price − issue costs. Check whether issue costs are given on face value or on issue price.
4Decide the type. If there is no maturity, it is irredeemable. If there is a maturity, it is redeemable.
5Find redemption value: face value plus any redemption premium.
6Apply the right formula. For irredeemable, I(1 − t) ÷ NP. For redeemable, use the average-based formula, or YTM if the question asks for it.
7Give before-tax or after-tax Kd as asked. If the question is silent and feeds into WACC, give after-tax Kd.
8State the answer as a percentage to two decimal places with a one-line conclusion.

Quickest way: Four-number method for debentures

When to use it: Use this for MCQs and for the first pass of written answers when the question allows the approximation formula.

Write four numbers in a row: I, NP, RV, n.
Compute the yearly extra cost (RV − NP) ÷ n first. If RV = NP, it is zero and the debt is effectively irredeemable in form.
Compute the average (RV + NP) ÷ 2 for the denominator.
Numerator = I(1 − t) + extra cost for after-tax. Divide once.
For MCQs, eliminate options that are equal to the coupon rate when there is a discount or issue cost, because Kd is higher than the coupon in that case. After-tax Kd must be lower than before-tax Kd.
In written answers, show each of the four numbers on separate lines. Step marks go for NP, interest, the formula and the final rate, even if the last division slips.

Common mistakes in Cost of Debt (Debentures, Bonds and Term Loans)

Using face value instead of net proceeds in the denominator.
Students see ₹100 debenture and stop reading, missing the discount or issue cost.
Fix: Always compute NP first. Circle every item that changes cash received: discount, premium, floatation cost, underwriting fee.
Calculating interest on issue price or net proceeds.
Students link interest to the cash received.
Fix: Interest is coupon rate × face value. Only the denominator uses NP.
Forgetting the redemption premium in RV.
The premium is mentioned in a separate line, such as redeemable at 5% premium.
Fix: Write RV = face value + premium before touching the formula.
Applying (1 − t) to the whole numerator, or to nothing.
Students are unsure whether tax relief applies to the discount or premium.
Fix: Follow the ICAI form: tax applies to interest, I(1 − t), and (RV − NP) ÷ n is added as is. State this as your working so the examiner sees the approach.
Using the wrong n.
Students use the issue date year or the total life instead of years remaining to redemption.
Fix: n is the number of years from the date of the cost calculation to redemption. Check the wording for remaining life.
Using before-tax Kd in WACC.
The question asks to find Kd and students stop at the pre-tax figure.
Fix: Whenever Kd feeds WACC, use after-tax Kd. Write both if unsure, and label them clearly.

Worked examples

Example 1

A company issues ₹10,00,000 of 12% irredeemable debentures at a 5% discount. Floatation costs are 2% of face value. The tax rate is 25%. Compute the cost of debt before tax and after tax.

Show the solution

Face value = ₹10,00,000. Annual interest I = 12% × 10,00,000 = ₹1,20,000.
Issue price = 95% of face value = ₹9,50,000.
Floatation costs = 2% × 10,00,000 = ₹20,000.
Net proceeds NP = 9,50,000 − 20,000 = ₹9,30,000.
Before-tax Kd = I ÷ NP = 1,20,000 ÷ 9,30,000 = 12.90%.
Interest after tax = 1,20,000 × (1 − 0.25) = ₹90,000.
After-tax Kd = 90,000 ÷ 9,30,000 = 9.68%.

Answer: Before-tax Kd = 12.90% and after-tax Kd = 9.68%.

Example 2

A company issues 10% redeemable debentures of ₹100 face value at ₹96 each. Floatation cost is ₹2 per debenture. They are redeemable at a 5% premium after 5 years. The tax rate is 30%. Compute the cost of debt before tax and after tax using the approximation formula.

Show the solution

Interest I = 10% × 100 = ₹10 per debenture.
Net proceeds NP = 96 − 2 = ₹94.
Redemption value RV = 100 + 5% × 100 = ₹105.
Yearly extra cost = (RV − NP) ÷ n = (105 − 94) ÷ 5 = 11 ÷ 5 = ₹2.20.
Average investment = (RV + NP) ÷ 2 = (105 + 94) ÷ 2 = ₹99.50.
Before-tax Kd = (10 + 2.20) ÷ 99.50 = 12.20 ÷ 99.50 = 12.26%.
After-tax interest = 10 × (1 − 0.30) = ₹7.
After-tax Kd = (7 + 2.20) ÷ 99.50 = 9.20 ÷ 99.50 = 9.25%.

Answer: Before-tax Kd = 12.26% and after-tax Kd = 9.25% (approximate).

Exam tips

Look for the words 'redeemable', 'at premium', 'floatation cost' and 'discount'. Each one changes NP or RV, and the examiner builds the question around them.
If the question asks for YTM or IRR of the debenture, do not use the average formula. Set up the NPV equation, try two rates, and interpolate. Show the NPV at each rate.
In MCQs, quickly check direction: discount or issue costs push Kd above the coupon, and tax pushes it below. Eliminate options that break this.
In WACC questions, Kd is one input. Compute it cleanly after tax, then carry it forward, and mention the source of funds with its weight.
Write the formula before substituting numbers. A correct formula with a small arithmetic slip still earns marks in the 70-mark written part.

Practice questions from Cost of Capital

Cost of Debt (Debentures, Bonds and Term Loans) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Debt (Debentures, Bonds and Term Loans): frequently asked questions

What is the formula for the cost of redeemable debentures?

The approximation is Kd = [I(1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2] for after-tax cost. Drop (1 − t) for the before-tax cost. Here I is annual interest, RV is redemption value, NP is net proceeds and n is years to redemption.

Should I use before-tax or after-tax cost of debt in WACC?

Use after-tax cost of debt, because interest is a tax-deductible expense. The tax shield reduces the real cost to the company. Equity and preference share costs are not adjusted for tax.

What is the difference between the approximation formula and the YTM method?

The approximation spreads the discount or premium evenly over the years and uses an average investment. YTM finds the exact rate that equates the present value of cash flows with net proceeds, using trial rates and interpolation. Use YTM when the question asks for it or gives discount factors.

How do I treat the cost of a term loan?

The after-tax cost is the interest rate × (1 − t). If there is a processing fee or other upfront charge, deduct it from the amount received and recompute the cost on that net amount.