MEASUREMENT OF COST OF DEBT - Accounts and Finance for Managers

The cost of the perpetual debt is nothing but the cost of raising the debt financial resource, in which the time period of repayment of the principal is not known. This particular specific source has two different classifications viz cost of interest and cost of debt.

Cost of interest (Ki)= Interest Sale value
Cost of Debt (Kd)= Tax adjusted Interest Sale value

Problem on Cost of Debt

  • A company has 10 percent perpetual debt of Rs.1,00,000. The tax rate is 35 per cent. Determine the cost of capital (before tax as well as after tax) assuming the debt is issued at i) at par ii) at 10% discount iii) at 10% premium.

Problem on Cost of Debt

The next method of computing the cost of debt is only for the debt finance which knows the repayment period of the principal and the payment of the interest periodicals.
This process of computation could be divided into two categories
First one is the periodical repayment of the principal along with the periodical payment of interest periodicals.

CIo= COIt + COPn (1 kd)t

The second one is the lump sum repayment of the principally only at the end of the term of the debenture.

lump sum repayment

Problem on cost of debt

  • A company issues a new 10 percent debentures of Rs.1,000 face value to be redeemed after 10 years. The debenture is expected to be sold at 5 percent discount. It will also involve flotation cost of 5 per cent of face value. The company’s tax rate is 35 per cent what would be the cost of debt be ? Illustrate the computations i) trial and error approach and ii) shortcut method.

Trial Error approach:

The first step is to determine the cash flows involved in the process of the debentures issue

Trial Error approach

The present value of the future cashflows should be found out one after the another.
The determination of present value at 7% and 8%

Trial Error approach

The value of Cost of debt is 8%
The short cut method is as follows

short cut method

I=Annual interest payment
T=tax rate
F=Flotation cost
d=Discount on debentures
pred=premium on redemption
pi=premium on issue of debentures
RV=Realisable value
SV=Sale value
Kd= 7.9%

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