Page 112 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 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 20:
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 1– 0.45  100

100 – 3 =  t + n
t=1 1+K d  1+K d 
DF PV of Cash Outflows ( )
Year Cash outflow ( )
7% 10% 7% 10%
1 - 7 8.25 5.389 4.868 44.96 40.16
7 100 0.623 0.513 62.30 51.30
PV of cash out flows 106.76 91.46
(-) PV of Cash inflows 97.00 97.00
9.76 5.54
Cost of debenture capital lies between 10 per cent and 12 per cent, because net present value 97
lies between the PV of 10 per cent and 12 per cent. Exact cost can be computed only with
interpolation formula:

 LDFPV NP 
K = LDF+  HDF- LDF  
d  LDFPV HDFPV 

Where,
LDF = Lower discounting factor.
HDF = Higher discounting factor.
LDFPV = Lower discounting factor present value.
HDFPV = Higher discounting factor PV.

PVCIF = Present value of cash inflows
NP = Net proceeds.

 106.76 – 97 
K = 7%+ 3×
d   106.76 – 91.46  
= 7%+1.91 = 8.91%

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