Cost of debt (kd)

After-tax cost of debt = cost of debt x (1- tax rate)
= k_d x (1 – t)

Note:
· Use interest rate on new marginal loan but not on existing or old debt.

Two methods are discussed to estimate the before-tax cost of debt (kd).
Yield-to-Maturity Approach
· This approach uses the familiar bond valuation equation. Assuming semi-annual coupon payments, the equation is

P0 = PMT₁/(1 + r_d/2) + ... PMT_n/(1 + r_d/2)ⁿ + FV / (1 + r_d/2)ⁿ

The six-month yield (r_d/2) is derived and then annualized it to arrive at the before-tax cost of debt, k_d.

Debt-Rating Approach
· This approach can be used if there isn't a reliable market price for a firm's debt.
· Based on the company's debt rating, the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that closely match that of the firm's existing debt.