Page 113 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

Short cut method Notes

 f+d+p – p /N
 I 1– t + 
K = r i m
p

RV+NP /2
Where,
I = Interest
t = Tax rate
f = Flotation cost
d = Discount
p = Premium on redemption
r
p = Premium on issue
i
RV = Redeemable value
NP = Net proceed
N = Maturity period of debt
m
 3– 0+0 – 0
15 1– 0.45 + /7
K =
p
100 – 97 /2
8.68
K = = 8.81%
p
98.5
Illustration 21: (Instalment repayment)
Hari Ram & Co. issued 14 per cent debentures aggregate at 2,00,000. The face value of debenture
is 100. Issue cost is 5 per cent. The company has agreed to repay the debenture in 5 equal
instalment at par value. Instalment starts at the end of the year. The company’s tax rate is 35 per
cent. Compute cost of debenture.
Solution:
Sales proceeds = Face value – Flotation cost = 100 – 5 = 95
Instalment amount = Face value ÷ No. of instalments = 100 ÷ 5 = 20.

Cash Outflow ( ) DF Factor PV of Cash Outflows ( )
Years
(NI + Instalment) 8% 13% 8% 13%
1 9.1 + 20 = 29.1 0.926 0.885 26.947 25.754
2 7.28 + 20 = 27.28 0.857 0.783 23.379 21.361
3 5.46 + 20 = 25.46 0.794 0.693 20.216 17.644
4 3.64 + 20 = 23.64 0.735 0.613 17.376 14.492
5 1.82 + 20 = 21.82 0.681 0.543 14.860 11.849
PV of cash out flows 102.778 91.230
PV of cash inflows 95.000 95.000
(+) 7.778 (-)3.770

 102.778– 95 
K = 8%+  13– 8 × 
d  102.778– 91.1 
 7.778 
= 8%+ 5× 

 11.678 
= 8% + 3.33 = 11.33 per cent

LOVELY PROFESSIONAL UNIVERSITY 107