Corporate Accounting and Financial Management · Cost of Capital

Cost of Debt: Formulas and Numerical Problems

Updated 11 October 2026 · Fact-checked

Cost of debt is the rate a company pays on borrowed money. For irredeemable debt, Kd = Interest ÷ Net proceeds. For redeemable debt, use the approximate yield formula with average amounts. Interest is tax-deductible, so after-tax Kd = Kd × (1 − t). Always take interest on face value and proceeds net of issue costs.

Understand Cost of Debt

Cost of debt (Kd) is the return lenders require on the money they lend. For the company it is the cost of using that borrowed money. Debt includes debentures, bonds and term loans.

Debt is cheaper than equity for two reasons. Lenders carry less risk because they are paid first. Also, interest is a deductible expense, so it saves tax. This saving is called the tax shield.

The key idea is that interest is always paid on the face value, but the company actually receives the net proceeds. Net proceeds = issue price less issue costs (flotation costs, underwriting, discount). So a debenture issued at a discount or with costs has a higher effective cost than its coupon rate.

Irredeemable debt is never repaid, so the cost is just interest divided by what you received. Redeemable debt is repaid at a fixed date, so the cost must also include the gain or loss at redemption, spread over the years. That is why redeemable debt uses an average-based formula.

For WACC you use the after-tax cost of debt, because the company's real burden is interest net of the tax saved.

Key rules to remember

Irredeemable debt (before tax): Kd = I ÷ NP; I = annual interest on face value. NP = net proceeds (issue price less issue costs).
Irredeemable debt (after tax): Kd (after tax) = [I ÷ NP] × (1 − t); t = tax rate as a decimal. Use this form for WACC.
Redeemable debt (approximate yield, before tax): Kd = [I + (RV − NP) ÷ n] ÷ [(RV + NP) ÷ 2]; RV = redemption value, n = years to maturity. If redeemed at a premium, RV is higher than face value.
Redeemable debt (after tax): Kd (after tax) = Kd (before tax) × (1 − t); Tax adjustment applies to the final rate when using the approximate formula with I as pre-tax interest.
Net proceeds: NP = Face value × issue price % − issue costs; Issue at discount lowers NP. Issue at premium raises NP.
Exact method: NP = Σ [I(1 − t) ÷ (1 + Kd)^n] + RV ÷ (1 + Kd)^N; Kd is the IRR found by trial and interpolation. Use it when the question asks for the exact or yield-to-maturity cost.

How to solve Cost of Debt questions

Follow this order for any cost of debt question. It prevents the usual errors in net proceeds and tax.

1Identify the type: irredeemable, redeemable, term loan or bond. Check whether the question wants before-tax or after-tax cost.
2Compute annual interest on the face value: face value × coupon rate.
3Compute net proceeds: face value × issue price %, then subtract issue costs.
4Find the redemption value. Add any redemption premium to face value. Note the number of years.
5Choose the formula. Irredeemable: I ÷ NP. Redeemable: the approximate formula with average of RV and NP in the denominator.
6Calculate the before-tax Kd as a percentage.
7Apply (1 − t) to get the after-tax cost, if asked.
8State the answer with the rate, rounded to two decimals, and a one-line conclusion.

Quickest way: Three-number shortcut

When to use it: Use when the question gives coupon, issue price, redemption price and years, and you need a quick yield estimate.

Write three numbers: I, NP and RV.
Compute the yearly gain or loss: (RV − NP) ÷ n. Add it to I for the top line.
Compute the average: (RV + NP) ÷ 2 for the bottom line.
Divide, then multiply by (1 − t) at the end.
If the debt is irredeemable, skip to I ÷ NP.

Common mistakes in Cost of Debt

Calculating interest on issue price or net proceeds instead of face value
Students see a discount or premium and apply the coupon to the amount received.
Fix: Interest is always coupon × face value. Only the denominator uses net proceeds.
Forgetting to deduct issue costs from proceeds
Costs are mentioned as a separate line and get ignored.
Fix: Always write NP = issue price − costs before doing anything else.
Using face value instead of redemption value in the redeemable formula
Students forget the premium on redemption.
Fix: Read the redemption terms. RV = face value + premium, if any.
Applying tax before the gain or loss on redemption is added
Students tax only the interest and mix it with the discount.
Fix: Calculate the before-tax rate first, then multiply by (1 − t). State the method if the question is silent.
Using the after-tax cost when the question asks before-tax, or the reverse
Students rush and skip the wording.
Fix: Underline 'before tax' or 'after tax' in the question and write both if unsure.

Worked examples

Example 1

Nirmal Industries Ltd issues 10% irredeemable debentures of ₹1,00,000 face value at a 5% discount. Issue costs are ₹2,000. The tax rate is 25%. Find the before-tax and after-tax cost of debt.

Show the solution

Interest I = 10% × ₹1,00,000 = ₹10,000.
Issue price = ₹1,00,000 × 95% = ₹95,000.
Net proceeds NP = ₹95,000 − ₹2,000 = ₹93,000.
Before-tax Kd = 10,000 ÷ 93,000 = 10.75%.
After-tax Kd = 10.75% × (1 − 0.25) = 8.06%.

Answer: Before-tax cost of debt is 10.75%. After-tax cost of debt is 8.06%.

Example 2

Kaveri Textiles Ltd issues 1,000 debentures of ₹100 each at 10% coupon, issued at ₹95 each, redeemable at par after 5 years. Issue costs are ₹1 per debenture. Tax rate is 30%. Find the after-tax cost of debt.

Show the solution

Interest per debenture I = 10% × ₹100 = ₹10.
NP = ₹95 − ₹1 = ₹94.
RV = ₹100 (redeemed at par), n = 5.
Yearly adjustment = (100 − 94) ÷ 5 = ₹1.20.
Numerator = 10 + 1.20 = ₹11.20.
Denominator = (100 + 94) ÷ 2 = ₹97.
Before-tax Kd = 11.20 ÷ 97 = 11.55%.
After-tax Kd = 11.55% × (1 − 0.30) = 8.08%.

Answer: Before-tax cost of debt is about 11.55% and after-tax cost is about 8.08%.

Exam tips

Write net proceeds as a separate line. Examiners give step marks for it even if the final rate is off.
State which formula you are using, such as the approximate yield method, unless the question asks for exact IRR.
Show both before-tax and after-tax rates when the question is unclear. It protects your marks.
In WACC problems, always carry the after-tax Kd forward, not the coupon rate.
Round only at the last step to avoid small differences in the answer.

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

Why do we use after-tax cost of debt in WACC?

Interest is deductible, so the company saves tax on it. The real cost to the company is interest less the tax saved. WACC should reflect this actual cost.

What is the cost of debt if debentures are issued at par with no costs?

The before-tax cost equals the coupon rate. The after-tax cost is coupon rate × (1 − t). For example, 12% debentures at a 25% tax rate cost 9% after tax.

How does a discount on issue affect cost of debt?

A discount reduces net proceeds while interest stays the same. This raises the effective cost above the coupon rate. For redeemable debt, the discount is also spread over the years in the formula.

Is the cost of a term loan calculated differently?

No. Use interest rate ÷ net amount received, then adjust for tax. If processing fees are charged upfront, deduct them from the loan amount to get net proceeds.