Page 112 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Generally, cost of debenture is equal to the interest rate, when debenture is issued at par and Notes
without considering tax. Cost will be less than the interest when we calculate cost after considering
tax since it is tax deductible. From the cost of capital point of view, debenture cost is always in
post tax cost.
Sometimes debentures may be issued at premium or discount. A company, which is having a
good track record, will be issued at premium and a company that is new or unknown to the
public or has a nominal or poor track record will be issued at discount. Whenever debentures
are issued at premium or discount the cost of debenture will be affected, it will decrease or
increase respectively.

Illustration 21: Rama & Co. has 15 per cent irredeemable debentures of 100 each for 10,00,000.
The tax rate is 35 per cent. Determine debenture assuming it is issued at (i) face value/par value
(ii) 10 per cent premium and (iii) 10 per cent discount.
Solution:
Issued at Pre-tax Post-tax
15 15(1–0.35)
(i) Face value = 15 percent = 9.8 percent
100 100

15 15(1–0.35)
(ii) 10% premium = 13.7 percent (100+10) = 8.9 percent
110
110
15 15(1–0.35)

(iii) 10% discount = 16.67 percent (100–10) = 10.9 percent
90
90
Cost of Redeemable Debentures/Debt

Redeemable debentures that, are having a maturity period or are repayable after a certain given
period of time. In other words, these type of debentures that are under legal obligation to repay
the principal amount to its holders either at certain agreed intervals during the duration of loan
or as a lump sum amount at the end of its maturity period. These type of debentures are issued
by many companies, when they require capital for fulfilling their temporary needs.
Cost of Redeemable Debentures:

n NI P
K =  t + n
d t  n
t=1 1+K d  1+K d
Where,
K = Cost of debentures.
d
n = Maturity period.
NI = Net interest (after tax adjustment).
P = Principal repayment in the year ‘n’.
n
Illustration 22: BE Company issues 100 par value of debentures carrying 15 per cent interest.
The debentures are repayable after 7 years at face value. The cost of issue is 3 per cent and tax rate
is 45 per cent. Calculate the cost of debenture.
Solution:

7 15

100 – 3 =  1 – 0.45  + 100 n
t
t=1 1+ K d  1+ K d 

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