Page 71 - DMGT409Basic Financial Management

Basic Financial Management

Notes Where,

D = Dividend per share.
f = Flotation cost (`).
d = Discount on issue of preference share (`).
p = Premium on redemption of preference shares (`).
r
p = Premium on issue of preference share (`).
i
N = Term of preference shares.
m
RV = Redeemable value of preference share.
NP = Net proceeds realized.

Illustration 13 (Lump sum repayment): A company issues ` 1,00,000, 10 per cent preference
shares of ` 100 each redeemable after 10 years at face value. Cost of issue is 10 per cent. Calculate
the cost of preference share.
d
D + ( f + + pr − pi )/N
K = m
p (RV + NP )/2
Where,
D = Dividend per share.
f = Flotation cost (`).

d = Discount on issue of preference share (`).
p = Premium on redemption of preference shares (`).
r
p = Premium on issue of preference share (`).
i
N = Term of preference shares.
m
RV = Redeemable value of preference share.
NP = Net proceeds realized.
+
+
10 (10000)/10
−
+
K =
+
p (100 90)/2
+
10 (1)
= 95 = 11.579 per cent
4.3.3 Cost of Debentures/Debt/Public Deposits
Companies may raise debt capital through issue of debentures or loan from fi nancial institutions
or deposits from public. All these resources involve a specifi c rate of interest. The interest paid

on these sources of funds is a charge on the profit & loss account of the company. In other words,
interest payments made by the firm on debt issue qualify tax deduction in determining net taxable

income. Computation of cost of debenture or debt is relatively easy, because the interest rate that
is payable on debt is fixed by the agreement between the firm and the creditors. Computation of

cost of debenture or debt capital depends on their nature. The debt/debentures can be perpetual
or irredeemable and redeemable cost of debt capital is equal to the interest paid on that debt, but
from company’s point of view it will be less than the interest payable, when the debt is issued at
par, since the interest is tax deductible. Hence, computation of debt is always after tax cost.

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