Question

a company issues rs 10,00,000; 10% debentures at a discount of 5%. the cost of floatation amounts to rs 30,000. the debentures are redeemable after 5 years. calculate cost of debt assuming a tax rate of 50%

Answer 1

Answer:

Before tax cost = 12.08%

After tax cost = 6.04%

Explanation:

Computing the before tax cost of debt as:

Before tax cost = 1 + 1/ n (P - NP) / 1/2 (P + NP)

where

N is number of years which is 5 years

1 is 100,000

P is 1,000,000

NP = 1,000,000 - (1,000,000 ×5% + 30,000)

NP = 1,000,000 - ( 50,000 + 30,000)

NP = 1,000,000 - 80,000

NP = 920,000

Putting the values above:

Before tax cost = 100,000 + 1/5 (1,000,000 - 920,000) / 1/2 (1,000,000 + 920,000)

= 100,000 + 16,000 / 960,000

= 116,000 / 960,000

Before tax cost = 12.08%

Computing the after tax cost is as:

After tax cost = Before tax cost ( 1 - t)

where

Before tax cost is 12.08

tax rate = 50 %

t = 0.5

Putting the values above:

After tax cost = 12.08 ( 1 - 0.5)

= 12.08 × 0.5

After tax cost = 6.04%