Financial Management and Business Data Analytics · Cost of Capital

Cost of Debt: Irredeemable and Redeemable Debentures

Updated 10 October 2026 · Fact-checked

Cost of debt is the rate a company pays on borrowed money, measured on net proceeds, not face value. For irredeemable debt use interest ÷ net proceeds. For redeemable debt use [interest + (redemption value − net proceeds) ÷ years] ÷ average of redemption value and net proceeds. Use interest × (1 − tax rate) for after-tax cost.

Understand Cost of Debt

Cost of debt is the annual return that lenders require, expressed as a percentage of the money the company actually receives. It covers debentures, bonds and term loans.

The key idea is net proceeds. A debenture of face value ₹100 may be issued at a discount or premium, and the company also pays issue (flotation) costs. So the cash received is: face value − discount (or + premium) − issue costs. Interest is always paid on face value, but the cost is measured against net proceeds.

Debt can be irredeemable (perpetual, never repaid) or redeemable (repaid after n years, possibly at a premium). For irredeemable debt, the cost is simply interest ÷ net proceeds. For redeemable debt, the lender also gains or loses when the amount repaid differs from the amount received, so that difference is spread over the years and added to the interest.

Interest is a tax-deductible expense. So the real burden on the company is lower than the interest paid. This gives the after-tax cost of debt, which is the figure used in WACC and capital structure decisions. Before-tax cost is used only when the question asks for it.

Two methods exist for redeemable debt: the approximation formula (fast, used in most exam problems) and the IRR / yield method (exact, found by trial and interpolation). Read the question to see which one is wanted.

Key rules to remember

Net proceeds (NP): NP = Face value − Discount (or + Premium) − Issue costs; Issue costs on a percentage basis: check whether the percentage applies to face value or to issue price.
Irredeemable debt, before tax: Kd = I ÷ NP; I = annual interest on face value (coupon rate × face value).
Irredeemable debt, after tax: Kd (after tax) = I × (1 − t) ÷ NP = Kd (before tax) × (1 − t); t = tax rate. Both forms give the same answer here.
Redeemable debt, before tax (approximate): Kd = [I + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; RV = redemption value, n = years to redemption. The denominator is the average of RV and NP.
Redeemable debt, after tax (approximate): Kd (after tax) = [I × (1 − t) + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; This applies the tax shield to interest only. Some solutions multiply the whole before-tax rate by (1 − t). Follow the method the question states and show it clearly.
Redeemable debt, exact (yield) method: NP = Σ I ÷ (1 + r)^k + RV ÷ (1 + r)^n, for k = 1 to n; Find r by trial at two rates and interpolate. Using pre-tax interest I gives the before-tax yield. Using I × (1 − t) in place of I gives an approximate after-tax yield. The tax effect of amortising the discount or premium is ignored here unless the question requires it.
Term loan: Kd (after tax) ≈ [Interest rate × (1 − t)] ÷ (1 − fee %); The upfront fee reduces net proceeds. Dividing by (1 − fee %) is the same as dividing by net proceeds per ₹100 borrowed (NP = ₹100 × (1 − fee %)). With no fee, Kd = Interest rate × (1 − t).

How to solve Cost of Debt questions

Use this order for any cost of debt question. It stops you mixing face value, issue price and redemption value.

1Identify the type: irredeemable or redeemable, debenture or term loan, and whether before-tax or after-tax cost is asked.
2Write the face value, coupon rate, issue price, issue cost and redemption value. Work out annual interest I = coupon rate × face value.
3Compute net proceeds NP = issue price − issue costs. Check whether the issue cost is on face value or issue price.
4Compute redemption value RV: face value plus any redemption premium. Note the number of years n.
5Apply the right formula: I ÷ NP for irredeemable, or the approximate formula for redeemable. Show each part: annual amortisation (RV − NP) ÷ n, and average (RV + NP) ÷ 2.
6Adjust for tax: use I × (1 − t) in the numerator for after-tax cost, as per your stated method.
7Convert to a percentage, round to two decimals, and write the final answer with a label: 'Cost of debt (after tax) = x%'.

Quickest way: Three numbers, one fraction

When to use it: Use this for redeemable debentures under time pressure in the objective section or the first part of a descriptive answer.

Write the three numbers: NP, RV and I (after tax if asked).
Compute the yearly gain or loss spread: (RV − NP) ÷ n.
Top = I (or I after tax) + that spread. Bottom = (RV + NP) ÷ 2.
Divide. For irredeemable debt, skip the spread and use Top = I and Bottom = NP.
In MCQs, check the direction: a discount or issue cost makes NP smaller, so the cost rises above the coupon rate. A premium on issue lowers it.

Common mistakes in Cost of Debt

Dividing interest by face value instead of net proceeds.
The coupon rate is quoted on face value, so students stop there.
Fix: Always compute NP first. Cost of debt equals coupon rate only when issue is at par with no issue costs.
Calculating interest on issue price or net proceeds.
Students treat the amount received as the amount borrowed for interest purposes.
Fix: Interest is always coupon rate × face value. Only the denominator uses NP.
Using face value instead of redemption value in the average (RV + NP) ÷ 2.
Premium on redemption is overlooked.
Fix: Write RV separately. If debentures are redeemed at a premium, RV = face value + premium.
Forgetting the tax adjustment, or taxing the wrong item.
The question asks for cost 'of debt' and students assume before tax.
Fix: Underline 'after tax' in the question. Apply (1 − t) to interest, and state the method you use.
Subtracting issue cost from the redemption value, or adding it to NP.
Confusion about which side issue costs affect.
Fix: Issue costs reduce the cash the company receives, so they reduce NP. They do not change RV.
Dropping the (RV − NP) ÷ n step for redeemable debt.
Students reuse the irredeemable formula.
Fix: If the question gives a redemption period, use the redeemable formula. If it says perpetual or irredeemable, use I ÷ NP.

Worked examples

Example 1

Ganga Industries Ltd issues 12% debentures of ₹1,000 each at a 5% discount. Issue costs are 2% of face value. The debentures are redeemable after 5 years at a 10% premium. The tax rate is 25%. Calculate the before-tax and after-tax cost of debt using the approximate method.

Show the solution

Interest I = 12% × ₹1,000 = ₹120.
Net proceeds NP = ₹1,000 − ₹50 (discount) − ₹20 (issue costs) = ₹930.
Redemption value RV = ₹1,000 + ₹100 (10% premium) = ₹1,100.
Annual amortisation = (₹1,100 − ₹930) ÷ 5 = ₹34.
Average investment = (₹1,100 + ₹930) ÷ 2 = ₹1,015.
Before-tax Kd = (₹120 + ₹34) ÷ ₹1,015 = ₹154 ÷ ₹1,015 = 15.17%.
After-tax interest = ₹120 × (1 − 0.25) = ₹90.
After-tax Kd = (₹90 + ₹34) ÷ ₹1,015 = ₹124 ÷ ₹1,015 = 12.22%.

Answer: Before-tax cost of debt = 15.17%; after-tax cost of debt = 12.22% (tax shield applied to interest only).

Example 2

Kaveri Textiles Ltd pays tax at 30%. It issues 11% irredeemable debentures of ₹100 each at a 5% premium. Issue cost is ₹3 per debenture. The company also takes a term loan at 10% interest with a 1% upfront processing fee. Calculate (a) the after-tax cost of the debentures and (b) the approximate after-tax cost of the term loan, treating it as perpetual.

Show the solution

(a) Interest I = 11% × ₹100 = ₹11.
Issue price = ₹100 + ₹5 = ₹105. NP = ₹105 − ₹3 = ₹102.
Before-tax Kd = ₹11 ÷ ₹102 = 10.78%.
After-tax Kd = ₹11 × (1 − 0.30) ÷ ₹102 = ₹7.70 ÷ ₹102 = 7.55%.
(b) After-tax interest rate = 10% × (1 − 0.30) = 7%.
Net proceeds per ₹100 borrowed = ₹100 − ₹1 = ₹99.
After-tax Kd = ₹7 ÷ ₹99 = 7.07%.

Answer: (a) After-tax cost of debentures = 7.55% (before tax 10.78%). (b) After-tax cost of the term loan ≈ 7.07%.

Exam tips

Always show NP, RV, I, and the amortisation figure on separate lines. Step marks are awarded even if the final percentage is slightly off.
Write which method you use (approximate or IRR) and whether tax is applied to interest only. This protects your marks if the examiner's method differs.
In MCQs, estimate first: issue at discount or with issue costs means cost above the coupon rate. Eliminate options that break this logic before calculating.
Check whether the question says 'perpetual', 'irredeemable' or gives a redemption date. This single word decides the formula.
If the question asks for the cost of debt to use in WACC, give the after-tax figure and say so.

Practice questions from Cost of Capital

Cost of Debt 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: frequently asked questions

What is the formula for cost of irredeemable debentures?

Before tax, Kd = I ÷ NP, where I is annual interest on face value and NP is net proceeds after discount, premium and issue costs. After tax, Kd = I × (1 − t) ÷ NP. If debentures are issued at par with no costs, the before-tax cost equals the coupon rate.

How do I treat flotation cost in the cost of redeemable debentures?

Subtract flotation cost from the issue price to get net proceeds. Then use NP in the formula, both in the amortisation term (RV − NP) ÷ n and in the average (RV + NP) ÷ 2. Flotation cost does not change the redemption value.

Is cost of debt before tax or after tax used in WACC?

The after-tax cost of debt is used in WACC, because interest is a deductible expense and gives a tax saving. Use the before-tax figure only when the question asks for it specifically.

Why is cost of debt lower than cost of equity?

Lenders have a fixed claim and are paid before shareholders, so they carry less risk and accept a lower return. Interest is also tax-deductible. Both factors make debt the cheaper source for the company.