Page 72 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

Cost of Irredeemable Debt/Perpetual Debt Notes

Perpetual debt provides permanent funds to the firm, because the funds will remain in the fi rm
till liquidation. Computation of cost of perpetual debt is conceptually relatively easy. Cost of

perpetual debt is the rate of return that lender expect (i.e., fixed interest rate). The coupon rate
or the market yield on debt can be said to represent an approximation of cost of debt. Bonds/
debentures can be issued at (i) par/face value, (ii) discount and (iii) premium. The following
formulae are used to compute cost of debentures or debt of bond:
I
1. Pre-tax cost: Kdi =
Por NP
I (1 t )
−
2. Post-tax cost: Kdi =
Por NP
Where,
Kdi = Pre-tax cost of debentures.
I = Interest
P = Principle amount or face value.

P = Net sales proceeds.
t = Tax rate.

Illustration 14: XYZ Company Ltd., decides to float perpetual 12 per cent, debentures of ` 100
each. The tax rate is 50 per cent. Calculate cost of debenture (pre and post tax cost).
Solution:
Rs .12
(i) Pre-tax cost: Kdi = = 12 per cent
100
12 (1 0.5− )
(ii) Post-tax cost: Kd = = 6per cent
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 15: 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.

LOVELY PROFESSIONAL UNIVERSITY 65