Cost of Debentures
Irredeemable Debt
Question 1
A company issues 10% debentures of Rs. 10,000 at par and expenses of issue are 4%. In this
example NP from issue of debentures is Rs. 10,000- Rs. 400= Rs. 9600 and interest payable
is Rs. 1000 per annum. In this case, calculate cost of debentures. Also calculate the cost of
debt after tax if tax is 30%.
FV= Rs. 10000
I= 10% i.e. Rs. 1000
Floatation Cost= 4% i.e. Rs. 400
NP = FV – FC = 10000- 400 = Rs. 9600
I
Ki= ×100
NP
Ki=10.42%
I (1−t)
Kd= ×100 ¿ Ki(1−t)
NP
Kd= Ki (1-t)= 10.42 x (1-.30)= 10.42x .70= 7.294%
Questions2:
Monica Ltd. Issued 10000, 14% debentures of Rs. 100 each at a discount of 5%. The
debentures are irredeemable. Cost of issue is 2% and the rate of tax is 50%. Calculate
the cost of capital.
Ki= (I/NP) *100
Kd=( I(1-t)/NP) * 100= Ki(1-t)
Given,
FV= Rs. 100 for 1 Debenture
FV= 10000 x 100= Rs. 1000000
I= 14% i.e. Rs. 14 for 1 debenture
I= Rs. 1,40,000
NP= FV- discount- FC= 100- 5- 2
NP= Rs. 93
NP= 1000000- 50000- 20000= 9300000
Ki= I/NP= 140000/930000= 0.1505x100= 15.05%
Kd= Ki (1-t)= 15.05 (1-0.5)= 15.05x0.5= 7.525%
Question 3:
New Deepak Co. Is willing to issue 1,000, 7% debentures of Rs. 100 each and for which
the company will have to incur the following expenses:
Underwriting commission 1.5%, Brokerage 0.5%, Printing and other expenses Rs. 500.
Assuming tax rate at 50%, find out the cost of debt capital.
Given,
FV= 1000*100= Rs. 100000
I= 7% i.e. Rs. 7000
NP= FV- Floatation Cost
NP= 100000- 1500- 500- 500= Rs. 97500
Ki= I/NP= 7000/97500= 0.717 *100= 7.17%
Kd= Ki(1-t)= 7.17*0.5= 3.59%
Redeemable Debt
MV −NP
i+
n
Cost of Debt (before-Tax)
MV + NP
Ki=( )
2
MV −NP
i(1−t)+
n
Cost of Debt (after-Tax) MV + NP
Kd=( )
2
Here,
MV= Maturity Value
I= Interest
NP= Net Proceeds
n= number of years
t= tax
Question 1:
A company issued 10,000 ten years 8% debentures of Rs. 100 each at 4% discount.
Under the terms of Debenture Trust, these debentures are to be redeemed after 10 years
at 5% premium. The cost of issue is 2%. Assuming tax rate at 50%, calculate the cost of
debt capital.
Solution:
Given
FV= Rs 100
I= Rs. 8
Discount= Rs. 4
N= 10 years
Redeemed at premium of 5%
Floatation Cost= Rs. 2
t= 0.5
NP= FV- Discount- Floatation Cost
NP= 100- 4- 2
NP= Rs. 94
MV= FV + Premium
MV= 100+ 5
MV= Rs. 105
Before Tax Cost of Capital
105−94
8+
10
105+94
Ki=( )
2
Ki= 9.15%
After Tax Cost of Capital
105−94
8(1−0. 5)+
10
105+94
Kd=( )
2
Kd= 5.11%
Question 2:
A company issues 1000, 10% debentures of Rs. 100 each at a premium of 5% with a
maturity period of 10 years. The cost of issue is 2%. The tax rate applicable to the firm
is 50%. Find out the cost of capital.
Ki= 9.55%
100−103
10(1−0 . 5)+
10
100+103
Kd=( )
2
Kd= 4.63%
Question 3
XYZ Co limited has debentures outstanding with 5 years left before maturity. The
debentures are currently selling for Rs. 90 (the face value is Rs. 100). The debentures
are to be redeemed at 5% premium. The interest is to be paid annually at a rate of 12%.
The firm’s tax rate is 35%. Calculate cost of debt.
Given,
FV= Rs. 100, I= RS 12
NP= RS. 90
n= 5 years
t= 35%
MV= FV + Prem
MV= 100+ 5= Rs. 105
Calculate onward.
Cost of Preference Share
Irredeemable Preference Share
After Tax
PD
Kp(after −tax)= × 100
NP
PD= Preferential Dividend
NP= Net Proceeds
If dividend tax is paid, the formula will be:
PD (1+ Dt )
Kp(after −tax)= ×100
NP
Before Tax
Kp ( after−tax )
Kp ( Before−Tax )=
1−t
Question 1
A Ltd. Issued 1,000, 10% preference share of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference capital if these shares are issued:
(i) at par
(ii) at 5% premium
(iii) at 2% discount
Solution:
Given, FV= Rs. 100
PD= Rs. 10
(i) At Par
NP= FV- FC= 100- 2= Rs. 98
10
Kp(after −tax)= ×100 = 10.20%
98
(ii) At premium
NP= 100+ 5 – 2= Rs. 103
Solve onwards.
(iii) At Discount
NP= 100 – 2 – 2 = Rs. 96
Solve onwards.
Illustration7:
Solution:
Given
FV= Rs. 100
PD= Rs. 8
Floatation Cost= Underwriting Commission + Brokerage+ Other exp (Rs. 5000)
NP= FV- FC= 100- 2- 1- 0.5
NP= Rs. 96.5
8
Kp(after −tax )= ×100 = 8.29%
96.5
Kp (Before- Tax)= 8.29/(1-0.5)= 8.29/0.5= 16.58%
Dt= 10% i.e. 0.1
PD (1+ Dt )
Kp(after −tax)= ×100
NP
8(1+0.1)
Kp(after −tax)= ×100= 9.11%
96.5
Kp (Before- Tax)= 9.11/0.5= 18.22%
Redeemable Preference Share
MV −NP
PD+
n
× 100
MV + NP
Kp ( after−tax )=
2
Kp ( after−tax )
Kp ( Before−Tax )=
1−t
Question1:
A Ltd issued at par 10,000, 10% Preference Shares of Rs. 100 each. These shares are
redeemable after 10 years at a premium of Rs. 5 per share. The cost of issue is Rs. 2 per
share. Find out the cost of Preference Capital. Assume tax rate is 50%.
Solution:
Given, FV= Rs. 100
PD= Rs. 10, n= 10years, t= 0.5
NP= FV- FC= Rs. 100- Rs. 2= RS. 98
MV= FV + Prem= Rs. 100 +Rs 5= Rs. 105
105−98
10+
10
× 100
105+ 98
Kp ( after−tax )=
2
Kp (after-tax)= 10.54%
Kp(Before tax)= 10.54/0.5=21.08%
Question 2:
X Ltd. Issued at Par 4000, 12% preference shares of Rs. 100 each. These shares are
redeemable after 10 years at a premium of Rs. 5 per share. The cost of issue is Rs. 3 per
share. Find out the cost of capital.
Solve this.