Page 111 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 5.4.3 Cost of Debentures/Debt/Public Deposits

Companies may raise debt capital through issue of debentures or loan from financial institutions
or deposits from public. All these resources involve a specific 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.

Cost of Irredeemable Debt/Perpetual Debt

Perpetual debt provides permanent funds to the firm, because the funds will remain in the firm
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) Pre-tax cost

I
K =
di
P or NP
(ii) Post-tax cost
I(1 – t)
K =
di
P or NP
Where,
K = Pre-tax cost of debentures.
di
I = Interest
P = Principal amount or face value.
NP = Net sales proceeds.
t = Tax rate.

Illustration 20: 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:

(i) Pre-tax cost
12
K di = = 12 per cent
100
(ii) Post-tax cost
12 1 - 0.5 
K = = 6 per cent
d
100

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