Page 111 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

Solution: Notes

(i) Pre-tax cost

12
K = = 12 per cent
di 100
(ii) Post-tax cost
12 1 - 0.5 
K = = 6 per cent
d 100
Generally, cost of debenture is equal to the interest rate, when debenture is issued at par and
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 19:

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 per cent = 9.8 per cent
100 100
(
15 15 1 – 0.35)
(ii) 10% premium = 13.7 per cent (100 +10) = 8.9 per cent
110 110
(
15 15 1 – 0.35)
(iii) 10% discount = 16.67 per cent (100 –10) = 10.9 per cent
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.

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