Overview of Cost of Debt and Preference
The cost of debt and preference is one of the most important concepts of modern day finance. It is one of the two constituent parts of the cost of capital of a company. The other part of cost of company is the cost of equity.
Calculation Procedure of Cost of Debt and Preference
There is a certain procedure of calculating the cost of debt and preference. The most basic component of the calculation of cost of debt and preference is to take the rate of a non-defaulting bond. As per the requirements of calculation the term period of the non-defaulting bond should resemble the corporate debt’s term structure.
A default premium is consequently added to it. It is normally assumed that the growth in the debt premium is directly proportional to the increase in the amount of debt. The main reason behind this is that along with the increase in the debt amount the risk goes up as well.
Under most circumstances the expenses incurred for paying the debts is considered to be an expense, which can be deducted. For this reason the cost of debt and preference is calculated after the taxes have been paid.
This serves to make the cost of debt and preference like the cost of equity as the cost of equity is also calculated after the taxes have been paid.
Application of Cost of Debt and Preference
In case of business entities that have been making profits in their business the rate of tax is normally used in order to discount the costs of debt and preference. The cost of debt and preference is normally used in case of the bigger business organizations.
Last Updated on : 27th June 2013