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What is Cost of Capital?How to calculate Cost of Debt?


Cost of capital: It is a minimum rate of return that a company earns on its investment.

Importance of Cost of Capital:
·         With the help of cost of capital management can determine the return on capital .
·         It helps to determine which source of finance is good for the company.

·         It helps to formulate optimal capital structure of a company.

 Cost of Debt: It is an interest rate that a company pays to its lenders or debenture holders whom it takes money to invest in company assets.

Importance of Financing through debt:
·         The lender does not participate in management and in profit they receive interest on a borrowed amount.
·         The interest received by lenders are tax deductible and treated as expense for a company.

·         Company has to keep more profit to meet the burden of paying interest regularly.

Net Proceeds: It is an amount which earn after subtracting related expenses from selling an asset.

Floating cost: It is an additional cost/expense incurred due to issuing or repaying a debenture/loan like brokerage cost.

Formula for Cost of Debt:

Cost of Irredeemable Debt
at par
At discount
At premium
Before Tax
After tax
Kd = (I/NP)* (1- tax rate)
Kd = (I/NP)*(1- tax rate)*100
NP = face value – discount amount
Kd = (I/NP)*(1- tax rate)*100
NP = face value + premium amount
Kdb =( I/NP)*100
Kda = I (1-T) or
Kda = Kdb (1-T)*100
Cost of Redeemable Debt
Before Tax
After Tax
Kd =  I+(f+ d+ pr-pi)/n/(RV+NP)/2
I(1-T)+(f+d+pr-pi)/n/(RV+NP)/2

Where,
Kd = Cost of debt
Kdb = Cost of Debt before tax
Kda = Cost of Debt after tax
I = interest payable annually
T = tax rate
D = discount on issue of debt
Pr = premium on redemption of debt
Pi = premium on issue of debt
RV = Redemption Value
F = Floatation cost
NP = Net Proceeds

Example: A debenture issues for Rs.5, 00,000, the coupon rate is 8%. The floating cost is 3% and tax is 30%.Find out cost of debt if issued :
·         At par
·         At 10% premium
·         At 8% discount

Solution:
·         At par
I = 500000*8/100 = 40000
floatation cost = 5,00,000*3/100 = 15,000
Kd = (I/ NP)*(1-tax)
= (40,000/5, 00,000 - 15,000)*(1-0.30)
=(40,000/ 4,85,000) * 0.7
= 5.77%       
            
At premium:
Kd = (I/ NP)*(1-tax)
= (40000 / (5, 00,000-15,000+50,000))*(1-030)
= (40000/5,35,000) *0.7
= 5.23%

At discount:
Kd = (I/ NP)*(1-tax)
= (40,000 / (5, 00,000-15000-40,000))*(1-0.30)
= (40,000/4,45,000)*0.7
=6.29%

Example: A debenture  issues for Rs.10, 00,000, coupon rate is 9% and the face value of bond is Rs.1000. The floating cost is 2% and marginal tax rate is 40%. Find out the cost of debt after tax and before tax.

Solution:
Cost of Debt before tax:
Kd = (I /NP)*100
= (90/ 980)*100
= 9.18%

Cost of debt after tax:
Kd = I (1-T)
= 9.18*(1-0.40)
= 5.51%

Example: Debenture issue at 9% Rs.1000 each worth Rs.2, 00,000 at 5% discount and after 10 years it redeem at 10% premium. Floating cost is 2% and tax rate is 40%.Find out the cost of debt.

floatation cost = 1000*2/100= 20
discount = 1000*5/100 =50
NP = 1000 -20-50 = 930
RV = 1000+100=1100

Kd = I (1-t) + (f+ d+ pr-pi)/n/ (RV+NP)/2
= 90 (1-0.40) + (20+50+100)/10 / (1100+930) / 2
= 6.99%
Or
Kd = (I (1-t)+ (RV-NP))/n / (RV+NP) /2

= (90(1-0.4) + (1100-930))/10/ (1100+930)/2
= (54 + 17)/1015
= 6.99%




Comments

  1. UnknownOctober 20, 2020 9:43 pm

    I observed in example no. 1 flotation cost 3% not considered, why??
    In second example flotation cost is 2% but in Ans Its 3%....
    Plz explain?????

    ReplyDelete
    Replies
    1. Jyoti YadavOctober 22, 2020 12:40 pm

      It's a mistake and i have updated this page. Thanks for observing.

      Delete

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