A company issues 12% debentures of face value Rs. 100 for Rs. 6,00,000. The floating charges on the issue are 5% on face value. The interest is payable annually, and the debentures are redeemable at a premium of 10% after 10 years. What will be the cost of debentures if the tax rate is 50%?
Answer (1)
To determine the cost of debentures for the company, we need to calculate the after-tax cost of debt. Here's how we can do it step by step:
Determine the Annual Interest Payment:
The company issues debentures at a 12% interest rate on the face value. So, the annual interest payment for Rs. 6,00,000 debentures with a face value of Rs. 100 is calculated as follows:
Annual Interest Payment = Face Value Total × Interest Rate = 6 , 00 , 000 × 100 12 = R s .72 , 000
Calculate the Tax Shield Effect:
Since the interest expense is tax-deductible, we need to calculate the tax shield effect. The tax rate provided is 50%.
After-tax Interest Payment = Annual Interest Payment × ( 1 − Tax Rate )
After-tax Interest Payment = 72 , 000 × ( 1 − 0.50 ) = R s .36 , 000
Consider the Redeemable Premium:
The debentures are redeemable at a 10% premium after 10 years. This means that at maturity, the company will pay more than the face value by 10% of the total debentures.
Premium on Redemption = Face Value Total × 100 10 = 6 , 00 , 000 × 0.10 = R s .60 , 000
Calculate the Cost of Debenture:
The cost of debentures is essentially the total interest paid over the period, including consideration for the premium paid at redemption, adjusted for taxes. Over 10 years:
Total After-tax Cost = 10 × After-tax Interest Payment + Present Value of Redemption Premium
For simplicity, in a typical case study without considering the present value, it may be expressed as:
Total Cost of Debt = 10 × 36 , 000 + 60 , 000 = R s .4 , 20 , 000
Summary:
The after-tax cost of the debentures, taking into account the interest payments and the redemption premium, is Rs. 4,20,000 over the life of the debentures, or Rs. 42,000 per year, if assumed directly without discounting the redemption to its present value.
In practice, however, the present value of future cash flows should be considered to give a more precise figure for cost of debt, typically calculated by present value techniques and specifically by Weighted Average Cost of Capital (WACC) approaches.
