IGNOU : M.COM : MCO 7 : UNIT 5 : Q - 1. How is the Cost of Debt Capital ascertained ? Give examples.

Ans. Cost of Long Term Debt

Debt may be issued at par, or at premium or at of discount. It may be perpetual or redeemable. The technique of computation of cost in each case has been explained in the following paragraphs.

(a) The formula for computing the Cost of Long Term debt at par is

                   Kd = (1 – T) R

Where

                   Kd = Cost pf long term debt

                    T = Marginal Tax Rate

                    R = Debenture Interest Rate

 For example, if a company has issued 10% debentures and the tax rate is 50%, the cost of debt will be

           (1 - .5) 10 = 5%

(b) In case the debentures are issued at premium or discount, the cost of debt should be calculated on the basis of net proceeds realised. The formula will be as follows :

                                                         I

                                           Kd   = ------   (1 – T)

                                                 Np

    Where

                          Kd = Cost of debt after tax

                          I = Annual Interest Payment

                         NP = Net Proceeds of Loans

                          T = Tax Rate

 Illustrations on Page No.-  [ 7-13 ] of    Unit - 5