The document discusses financial management related to the cost of capital, specifically focusing on the computation of the cost of debt. It outlines formulas for calculating the cost depending on whether debentures are issued at par, premium, or discount, as well as providing various examples to illustrate these calculations. Additional details about taxes and their impact on the cost of debt are also included.

1. FINANCIAL MANAGEMENT
COST OF CAPITAL
BY:
SMT.UMA MINAJIGI REUR
HEAD, DEPT. OF COMMERCE& MANAGEMENT
SMT. V G DEGREE COLLEGEFOR WOMEN, KALABURAGI

2. COST OF DEBT

3. COMPUTATION OF COST OF CAPITAL
Computation of overall cost of capital involves:
 Computation of cost of specific source of finance.
 Computation of weighted cost of capital.

4. COMPUTATION OF COST OF SPECIFIC SOURCE OF
FINANCE.
Specific sources of finance includes:
 Cost of Debt
 Cost of Preference capital
 Cost of Equity Capital
 Cost of Retained earnings

5. COST OF DEBT
 Cost of debt is the rate of interest payable on debt.
 Cost of debt (i.e, debentures and long term debt) is
defined in terms of the required rate of return that the
debt, investment must yield to protect the shareholders
interest. Hence, Cost of debt is contractual interest rate,
adjusted further for the tax liability of the firm.

6. COST OF DEBT
Where , Kd = Cost of Debt, I – Interest, P = Principal
• Cost of Debt after tax:
Where , Kd = Cost of Debt, T = Tax rate, R – Rate of Interest
Kd = (1-T) R
• Cost of Debt before tax:

7. COST OF DEBT
1. Company issues 12% debentures. Its marginal tax rate is 50%.Thus
effective cost of these debentures will be as follows:
Solution:
Kd = (1-T) R
Given:
T = 50%
R = 12%
Kd = (1-T) R
Kd = (1 – 0.50) * 12%
= 0.50 * 12 / 100 = 0.06
= 0.06 * 100 = 6%

8. COST OF DEBT
When the debentures are issued at par:
Cost of debt will be calculated by the following formula:
Kd = (1-T) R
When the debentures are issued at discount:
Cost of debt will be calculated by the following formula:
𝑲𝒅 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
𝟏 − 𝑻 𝒐𝒓 𝑲𝒅 =
𝑰
𝑷
(𝟏 − 𝑻)
Where,
Kd = Cost of debt
I = Interest on debentures
P = Net proceeds of debentures (Face value – Discount)
T = Tax Rate

9. COST OF DEBT
When the debentures are issued at premium:
Cost of debt will be calculated by the following formula:
𝑲𝒅 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
𝟏 − 𝑻 𝒐𝒓 𝑲𝒅 =
𝑰
𝑷
(𝟏 − 𝑻)
Where,
Kd = Cost of debt
I = Interest on debentures
P = Total proceeds (Principal + Premium)
T = Tax Rate

10. COST OF DEBT
2. A Company issues Rs.50,000 8% debentures at
par. What is the cost of debt?
Solution:
Cost of debt before tax:
𝑲𝒅 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
𝒐𝒓 𝑲𝒅 =
𝑰
𝑷
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = 50,000 * 8% = 50,000 * 8/100 = 4,000
𝑲𝒅 =
𝟒𝟎𝟎𝟎
𝟓𝟎,𝟎𝟎𝟎
∗ 𝟏𝟎𝟎 = 8%
Cost of Debt = 8%

11. COST OF DEBT
3. A Company issues Rs.50,000 8% debentures at par. The tax
rate is 50%. What is the cost of debt?
Solution:
Cost of debt after tax:
Kd = (1-T) R
Kd = (1-50%) 8%
Kd = (1-0.50) 8/100
Kd = 0.50 * 8/100 = 0.04 = 0.04 *100 = 4%
Cost of Debt = 4%

12. COST OF DEBT
4. If the debentures are issued at par:
Face Value of debentures Rs. 1,000
Flotation costs 2%
Net Proceeds ?
Solution:
Net Proceeds = Face Value – Flotation Cost
= 1000 – 20 (2% of 1000 = 1000 *
2/100)
= 980
Net Proceeds = 980

13. COST OF DEBT
5. If the debentures are issued at discount:
Issue price of debentures Rs. 1,000
Flotation costs 2%
Discount is 5%
Net Proceeds ?
Solution:
Net Proceeds = Face Value – discount - Flotation Cost
= 1000 – 50 (5% of 1000) = 950 – Flotation Cost
= 950 - (2% of 950 = 950 * 2/100)
= 950 – 19
= 931
Net Proceeds = 931

14. COST OF DEBT
6.
Face Value of debentures = Rs.1,000
Premium = 10%
Flotation Cost = 2%
Net Proceeds ?
Solution:
Net Proceeds = Face Value + Premium – Cost of Flotation
= 1000 + 100 – 2% on 1100
= 1100 – 22
= 1078
Net Proceeds = 1078

15. COST OF DEBT
DEBENTURES ARE ISSUED AT PAR, AT A PREMIUM AND
DISCOUNT.
When the debentures are issued at face value, it is called
Debentures issued at par.
In such case cost of debt is calculated as follows:
𝑲𝒅 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
𝟏 − 𝑻 𝒐𝒓 𝑲𝒅 =
𝑰
𝑷
(𝟏 − 𝑻)
or
Kd = (1-T) R
Where,
Kd = Cost of debt
I = Interest on debentures
P = Net proceeds of debentures (Face value – Discount)
T = Tax Rate

16. 7. Company issuesRs.80,000 9% debentures at par. The tax rate
applicable to the company is 50%. Compute the cost of debt capital.
 Solution:
𝑲𝒅 =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
𝟏 − 𝑻 𝒐𝒓 𝑲𝒅 =
𝑰
𝑷
(𝟏 − 𝑻)
Kd = Cost of Debt
I = Interest = 7,200 (80,000 *9/100)
T – Tax rate = 50% = 0.50
P = Issue Price = 80,000
𝑲𝒅 =
𝑰
𝑷
𝟏 − 𝑻
𝑲𝒅 =
𝟕, 𝟐𝟎𝟎
𝟖𝟎, 𝟎𝟎𝟎
∗ 𝟏 − 𝟎. 𝟓𝟎
Kd = 0.09 * 0.50
Kd = 0.045 * 100 = 4.5%
Cost of Debt = 4.5 %

17. DEBT IS ISSUED AT A PREMIUM
When the debentures are issued more than the face value, it is called
premium.
P = Net Proceeds (i.e, issue price)
= Face Value + Premium

18. 8. VGW company issues Rs.80,000 9% debentures at a premium
of 10%. The tax rate applicable to the company is 60%. Compute
the cost of debt capital.
Solution:
Computation of cost of debt capital
𝑲𝒅 =
𝑰
𝑷
𝟏 − 𝑻
Where,
Kd = Cost of debt
I = Interest = 7200 ( 80,000 * 9/100)
T = Tax = 60% or 0.60
P = Net Proceeds (i.e, issue price) = 88,000
Face Value + Premium
80,000 + 8,000 = 88,000
𝑲𝒅 =
𝟕𝟐𝟎𝟎
𝟖𝟖, 𝟎𝟎𝟎
∗ 𝟏 − 𝟎. 𝟔𝟎
𝑲𝒅 =
𝟕𝟐𝟎𝟎
𝟖𝟖,𝟎𝟎𝟎
∗ 𝟏 − 𝟎. 𝟔𝟎
Kd = 0.081 * 0.40 = 0.0324
= 0.0324 * 100 = 3.24%
Cost of Debt = 3.24 %

19. COST OF REDEEMABLE DEBT
When the debt is issued to be redeemed after a certain period during the
life time of a firm. Such a debt issue is known as Redeemable debt.
So the cost of redeemable debt capital is calculated is as follows:
Where,
Kd = Cost of debt
R = Rate of Interest
N = Number of years to maturity
F = Face Vale or Redeemable Value
T = Tax Rate
P = Issue Price

20. CONDITIONS FOR ISSUE OF DEBENTURES
Case Conditions Repayment
1 Debentures issued at Par Repayable at Par
2 Debentures issued at Discount Repayable at Par
3 Debentures issued at Premium Repayable at Par
4 Debentures issued at Par Repayable at Premium
5 Debentures issued at Discount Repayable at Premium

21. 18. A Company issues Rs.5,00,000 10% Debentures at a discount of
5%. The cost of flotation amount of Rs.15,000. The debentures are
redeemable after 5 years. The tax rate is 50%. Compute the cost of
debt capital.
Solution:
Where,
Kd = Cost of debt
R = Rate of Interest 10% on 5,00,000 – Rs.50,000
N = Number of years to maturity = 5 Years
F = Face Vale or Redeemable Value = Rs.5,00,000
T = Tax Rate = 50% = 0.50
P = Issue Price
= Face Value – Discount – Flotation Cost
= 5,00,000 – 25,000 (5% on 5,00,000) – 15,000
= 4,60,000

22. Kd (Cost of Debt) = 6.04%

23. 19. Company issues debentures of Rs.2,00,000 and realises
Rs.1,96,000 after allowing 2% commission to brokers. The
debentures carry on interest rate of 10%. The debentures
are due for maturity at the end of the 10th year. You are
required to calculate the effective cost of debt capital
after tax. If the tax is 55%.

24. 20. Pooja company issued 15000 10 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 (i.e, cost of floatation) of issue is 2%. Calculate the cost of debt of capital presuming a tax
of 50%.
Solution:
Where,
Kd = Cost of debt
R = Rate of Interest 8% on 15,00,000 – Rs.1,20,000
N = Number of years to maturity = 10Years
F = Face Vale or Redeemable Value = Issue value + Premium
= Rs.15,00,000 + 5% of 15,00,000
= Rs. 15,00,000 + 75,000
= Rs. 15,75,000
T = Tax Rate = 50% = 0.50
P = Issue Price
= Face Value – Discount – Flotation Cost
= 15,00,000 – 60,000 (4% on 15,00,000) – 28,800 (2% of 14,40,000)
= 14,40,000 – 28,800
= 14,11,200

25. 𝑲𝒅 =
𝟏 − 𝟎. 𝟓𝟎 𝟏, 𝟐𝟎, 𝟎𝟎𝟎 +
𝟏
𝟏𝟎
(𝟏𝟓, 𝟕𝟓, 𝟎𝟎𝟎 − 𝟏𝟒, 𝟏𝟏, 𝟐𝟎𝟎)
𝑰
𝟐
(𝟏𝟓, 𝟕𝟓, 𝟎𝟎𝟎 − 𝟏𝟒, 𝟏𝟏, 𝟐𝟎𝟎)
𝑲𝒅 =
𝟎. 𝟓𝟎 𝟏, 𝟐𝟎, 𝟎𝟎𝟎 +
𝟏
𝟏𝟎
(𝟏, 𝟔𝟑, 𝟖𝟎𝟎)
𝑰
𝟐
∗ (𝟐𝟗, 𝟖𝟔, 𝟐𝟎𝟎)
𝑲𝒅 =
0.50 )1,20,000 + 16,380
14,93,100
𝑲𝒅 =
𝟎. 𝟓𝟎 ∗ 𝟏, 𝟑𝟔, 𝟑𝟖𝟎
𝟏𝟒, 𝟗𝟑, 𝟏𝟎𝟎
𝑲𝒅 = 𝟎. 𝟎𝟒𝟓𝟔𝟕 ∗ 𝟏𝟎𝟎
Kd = 4.57%
Where,
Kd = Cost of debt
R = Rs.1,20,000
N = 10 Years
F = Rs. 15,75,000
T = 0.50
P = 14,11,200

26. 21. A 5 years of Rs.100 debentures of a firm can be sold for a Net price of Rs.96.50. The
coupon rate of interest is 14% p.a. and the debenture will be redeemable at 5%
premium on maturity. The firms tax rate is 40%. Compute cost of debt before and
after tax.
Solution:
Where,
Kd = Cost of debt
R = Rate of Interest 14% = 14/100 * 100 = 14
N = Number of years to maturity = 5 Years
F = Face Vale or Redeemable Value = Issue value + Premium
= Rs.100 + 5% of 100
= Rs. 100 + 5
= Rs. 105
T = Tax Rate = 40% = 0.40
P = Net Proceeds = 96.50

27. 𝑲𝒅 =
𝟏 − 𝑻 𝑹 +
𝟏
𝑵 (𝑭 − 𝑷)
𝑰
𝟐
(𝑭 + 𝑷)
𝑲𝒅 =
𝟏𝟒 +
𝟏
𝟓
(𝟏𝟎𝟓 − 𝟗𝟔. 𝟓𝟎)
𝑰
𝟐 (𝟏𝟎𝟓 − 𝟗𝟔. 𝟓𝟎)
𝑲𝒅 =
𝟏𝟓.𝟕
𝟏𝟎𝟎.𝟐𝟓
𝑲𝒅 = 𝟎. 𝟏𝟓𝟔 ∗ 𝟏𝟎𝟎
Kd = 15.66%
Cost of Debt before tax
𝑲𝒅 =
𝑹 +
𝟏
𝑵 (𝑭 − 𝑷)
𝑰
𝟐
(𝑭 + 𝑷)
Where,
Kd = Cost of debt
R = Rate of Interest = 14
N = 5 Years
F = Rs. 105
T = Tax Rate = 40% = 0.40
P = Net Proceeds = 96.50

28. 𝑲𝒅 =
𝟏 − 𝟎. 𝟒𝟎 𝟏𝟒 +
𝟏
𝟓
(𝟏𝟎𝟓 − 𝟗𝟔. 𝟓𝟎)
𝑰
𝟐
(𝟏𝟎𝟓 + 𝟗𝟔. 𝟓𝟎)
𝑲𝒅 =
𝟎. 𝟔𝟎 ∗ 𝟏𝟓. 𝟕
𝟏𝟎𝟎. 𝟕𝟓
𝑲𝒅 = 𝟎. 𝟎𝟗𝟑𝟒 ∗ 𝟏𝟎𝟎
Kd = 9.34%
Cost of Debt after tax
Where,
Kd = Cost of debt
R = Rate of Interest = 14
N = 5 Years
F = Rs. 105
T = Tax Rate = 40% = 0.40
P = Net Proceeds = 96.50
𝑲𝒅 =
𝟏 − 𝑻 𝑹 +
𝟏
𝑵
(𝑭 − 𝑷)
𝑰
𝟐
(𝑭 + 𝑷)

29. THANK YOU