0A company may borrow funds/obtain debt funds, and it has to pay interest on the amount borrowed which is usually a fixed rate of interest. Payment of interest is a charge on profits on the company. There is a need for effective computing cost of debt to the company, denoted by Kd. The effective cost of debt depends upon net loan proceeds received, interest rate, tax implication and redemption value. We will discuss the same in later chapters.
Irredeemable debt
No principal repayment, however, interest has to be serviced periodically.
Redeemable debt
The principal amount needs to be repaid at the end of a finite life or maturity along with periodical service of interest
However, the rules for computing cost of debts are different for irredeemable and redeemable debts.
Important points to be considered before computing Kd:
Flotation cost: If a company raises funds by issue of debentures, bonds, equity shares, preference shares, then it will have to incur a certain cost to procure these funds, such as printing cost of the prospectus, debenture application or share application form, brokerage, commission to underwriters, advertisement costs, etc.
Flotation cost reduces the amount of fund available with the company, hence amount raised becomes irrelevant and net proceeds available becomes relevant.
To illustrate: Co. Big limited issued 10,000 12% debentures at INR 100/deb. And also incurred INR 1,00,000 as floatation cost, hence funds available with the company is INR 900,000. The relevant figure is INR 900,000.
Taxation: Interest on debt is a tax-deductible expense. Hence interest cost saves tax and therefore while computing effective cost of debt to the company, the tax saving on the interest will be considered.
100 basis points = 1 %
Cost of irredeemable debt = I (1-t) / NP
(Using approximation method)
Cost of redeemable debt = [I (1-t) + (RV - NP)/n] / (RV+NP)/2
(Using approximation method)
Where NP = Net proceeds from debentures in case of new issue of debt or current market price in case of existing debt
t = Tax (in decimals)
RV = Redemption value
n= Number of years to maturity/redemption
Computation of cost of floating or variable debt:
Floating rate debts are attached to some base rate such as prime lending rate (‘PLR’), Mumbai Interbank Offer Rate (‘MIBOR’), the base rate of State Bank of India or any similar rate. The companies issuing Floating rate debt instruments attach the interest rate payable by them to such base rates. If a company issues a bond at PLR + 5% (2% is called premium interest), if PLR is 10%, interest payable by the company is 15%, and if PLR is 11%, interest payable is 16%.
Cost of Convertible Debenture
In case of convertible debentures, debenture holders have the option to either get the debentures redeemed into the cash or get specified numbers of shares instead of cash. Debentures can be partly convertible or fully convertible. The calculation of the cost of convertible debentures is very much similar to the redeemable debentures. While determining the redemption value of the debentures, all the debenture holders will choose the option which has the higher value and accordingly higher value is considered as the redemption value to calculate the cost of debt.
As per Yield method :
NP = CF1 / (1+ Kd) + CF2 / (1+ Kd)2 + CF3 / (1+ Kd)3 + … + CFn / (1+ Kd)n
CF means cash outflow after tax. Cash outflow can be regarding interest payment or/and principal repayments.
Here, we have to understand that we are equating present value of cash inflow with the present value of cash outflow, discounted at Kd. This model is rarely used in computing Kd as it is mostly used to compute the return to investors, also known as yield to maturity (YTM) where instead of using Kd, we use YTM. We will study YTM concept in CA final.
Amortisation method is similar to Yield method, with the only difference that this method is used when there is repayment of principal scheduled over the life of bond/debenture, instead of one-time repayment at the end.
How to identify that this method is to be used?
When one-time repayment feature is missing, and question either specify present value method or gives a hint that present/amortisation value method should be used, then think of this method.
