Cost of Debentures

Irredeemable Debt

Question 1

A company issues 10% debentures of Rs. 10,000 at par and expenses of issue are 4%. In this
example NP from issue of debentures is Rs. 10,000- Rs. 400= Rs. 9600 and interest payable
is Rs. 1000 per annum. In this case, calculate cost of debentures. Also calculate the cost of
debt after tax if tax is 30%.

FV= Rs. 10000

I= 10% i.e. Rs. 1000

Floatation Cost= 4% i.e. Rs. 400

NP = FV – FC = 10000- 400 = Rs. 9600

I
Ki= ×100
NP

Ki=10.42%

I (1−t)
Kd= ×100 ¿ Ki(1−t)
NP

Kd= Ki (1-t)= 10.42 x (1-.30)= 10.42x .70= 7.294%

Questions2:

Monica Ltd. Issued 10000, 14% debentures of Rs. 100 each at a discount of 5%. The
debentures are irredeemable. Cost of issue is 2% and the rate of tax is 50%. Calculate
the cost of capital.

Ki= (I/NP) *100

Kd=( I(1-t)/NP) * 100= Ki(1-t)

Given,

FV= Rs. 100 for 1 Debenture

FV= 10000 x 100= Rs. 1000000

I= 14% i.e. Rs. 14 for 1 debenture

I= Rs. 1,40,000

NP= FV- discount- FC= 100- 5- 2

NP= Rs. 93

NP= 1000000- 50000- 20000= 9300000

Ki= I/NP= 140000/930000= 0.1505x100= 15.05%

Kd= Ki (1-t)= 15.05 (1-0.5)= 15.05x0.5= 7.525%

Question 3:

New Deepak Co. Is willing to issue 1,000, 7% debentures of Rs. 100 each and for which
the company will have to incur the following expenses:

Underwriting commission 1.5%, Brokerage 0.5%, Printing and other expenses Rs. 500.
Assuming tax rate at 50%, find out the cost of debt capital.

Given,

FV= 1000*100= Rs. 100000

I= 7% i.e. Rs. 7000

NP= FV- Floatation Cost

NP= 100000- 1500- 500- 500= Rs. 97500

Ki= I/NP= 7000/97500= 0.717 *100= 7.17%

Kd= Ki(1-t)= 7.17*0.5= 3.59%

 Redeemable Debt

MV −NP
i+
n
Cost of Debt (before-Tax)
MV + NP
Ki=( )
2

MV −NP
i(1−t)+
n
Cost of Debt (after-Tax) MV + NP
Kd=( )
2

Here,

MV= Maturity Value

I= Interest

NP= Net Proceeds

n= number of years

t= tax

Question 1:

A company issued 10,000 ten years 8% debentures of Rs. 100 each at 4% discount.
Under the terms of Debenture Trust, these debentures are to be redeemed after 10 years
at 5% premium. The cost of issue is 2%. Assuming tax rate at 50%, calculate the cost of
debt capital.

Solution:
Given
FV= Rs 100
I= Rs. 8
Discount= Rs. 4
N= 10 years
Redeemed at premium of 5%
Floatation Cost= Rs. 2
t= 0.5

NP= FV- Discount- Floatation Cost

NP= 100- 4- 2
NP= Rs. 94

MV= FV + Premium
MV= 100+ 5
MV= Rs. 105

Before Tax Cost of Capital

105−94
8+
10
105+94
Ki=( )
2
Ki= 9.15%

After Tax Cost of Capital

105−94
8(1−0. 5)+
10
105+94
Kd=( )
2

Kd= 5.11%

Question 2:

A company issues 1000, 10% debentures of Rs. 100 each at a premium of 5% with a
maturity period of 10 years. The cost of issue is 2%. The tax rate applicable to the firm
is 50%. Find out the cost of capital.

Ki= 9.55%

100−103
10(1−0 . 5)+
10
100+103
Kd=( )
2

Kd= 4.63%

Question 3

XYZ Co limited has debentures outstanding with 5 years left before maturity. The
debentures are currently selling for Rs. 90 (the face value is Rs. 100). The debentures
are to be redeemed at 5% premium. The interest is to be paid annually at a rate of 12%.
The firm’s tax rate is 35%. Calculate cost of debt.

Given,
FV= Rs. 100, I= RS 12
NP= RS. 90
n= 5 years
t= 35%
MV= FV + Prem
MV= 100+ 5= Rs. 105
Calculate onward.
 Cost of Preference Share
Irredeemable Preference Share

After Tax

PD
Kp(after −tax)= × 100
NP

PD= Preferential Dividend

NP= Net Proceeds

If dividend tax is paid, the formula will be:

PD (1+ Dt )
Kp(after −tax)= ×100
NP

Before Tax

Kp ( after−tax )
Kp ( Before−Tax )=
1−t

Question 1

A Ltd. Issued 1,000, 10% preference share of Rs. 100 each. Cost of issue is Rs. 2 per
share. Calculate cost of preference capital if these shares are issued:

(i) at par

(ii) at 5% premium

(iii) at 2% discount

Solution:

Given, FV= Rs. 100

PD= Rs. 10

(i) At Par

NP= FV- FC= 100- 2= Rs. 98

10
Kp(after −tax)= ×100 = 10.20%
98

(ii) At premium

NP= 100+ 5 – 2= Rs. 103

Solve onwards.
(iii) At Discount
NP= 100 – 2 – 2 = Rs. 96
Solve onwards.

Illustration7:

Solution:

Given

FV= Rs. 100

PD= Rs. 8

Floatation Cost= Underwriting Commission + Brokerage+ Other exp (Rs. 5000)

NP= FV- FC= 100- 2- 1- 0.5

NP= Rs. 96.5

8
Kp(after −tax )= ×100 = 8.29%
96.5

Kp (Before- Tax)= 8.29/(1-0.5)= 8.29/0.5= 16.58%

Dt= 10% i.e. 0.1

PD (1+ Dt )
Kp(after −tax)= ×100
NP

8(1+0.1)
Kp(after −tax)= ×100= 9.11%
96.5

Kp (Before- Tax)= 9.11/0.5= 18.22%

 Redeemable Preference Share
MV −NP
PD+
n
× 100
MV + NP
Kp ( after−tax )=
2

Kp ( after−tax )
Kp ( Before−Tax )=
1−t

Question1:

A Ltd issued at par 10,000, 10% Preference Shares of Rs. 100 each. These shares are
redeemable after 10 years at a premium of Rs. 5 per share. The cost of issue is Rs. 2 per
share. Find out the cost of Preference Capital. Assume tax rate is 50%.

Solution:

Given, FV= Rs. 100

PD= Rs. 10, n= 10years, t= 0.5

NP= FV- FC= Rs. 100- Rs. 2= RS. 98

MV= FV + Prem= Rs. 100 +Rs 5= Rs. 105

105−98
10+
10
× 100
105+ 98
Kp ( after−tax )=
2

Kp (after-tax)= 10.54%

Kp(Before tax)= 10.54/0.5=21.08%

Question 2:

X Ltd. Issued at Par 4000, 12% preference shares of Rs. 100 each. These shares are
redeemable after 10 years at a premium of Rs. 5 per share. The cost of issue is Rs. 3 per
share. Find out the cost of capital.

Solve this.