CORPORATE FINANCIAL MANAGEMENT

COST OF DEBT
Companies may raise debt capital through issue of debenture or raise loans from
the financial institutions or deposits from the public. All these resources involve
a specific rate of interest. The interest paid on these sources of funds is a charge
on a profit &loss account of company. In other words interest payment made by
the firms on debt issue qualifies tax deduction in determining net taxable
income. Computation of Cost of debenture is relatively easy, because the
interest rate that is payable on debt is fixed by the agreement between the firm
and the creditors. Computation of debt capital debenture depends on nature.
Debt can be perpetual or irredeemable &redeemable, cost of debt capital is
equal to the interest paid on that debt, but from company point of view it will be
less than the interest payable when debt issued at par since the interest is tax is
deductible.
Cost of debt is the interest rate that the company pays on its debt content of the
capital structure. It can be measured as before tax cost of debt or after tax cost
of debt. Tax plays an important role as the debenture interest expense is allowed
as an expense for tax purposes. Debt may be issued at par, at premium or at a
discount. It may be irredeemable or redeemable
Cost of Irredeemable debt:
Irredeemable debentures are those debentures issuing by which the company
has no obligations to pay back the value of the debenture on some fixed date or
time and has the full authority to choose any time to pay back the debt until the
company is a going entity and does not default in its interest payments. So we
take into account only the sale value (SV) while evaluating the cost of
irredeemable debentures.
Before tax cost of Irredeemable debt :Interest/Sale Proceeds or Sale value of debentures
Or
I / SV

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Where:
I = Annual fixed interest and
SV = Sale value of debenture
After tax cost of Irredeemable debt :Kd = (1-T) * Before tax cost of debt
Kd = (1-T) * I/SV

Where:
T = Tax rate
Kd = After tax cost of debt
I = Annual interest payment
SV = Sale value of debentures
The SV of debentures would be adjusted for issuance at discount or premium.
This would be net of commission and floatation costs if any.
Example:
Debt issued at par :Let us consider an example where a concern sells a new issue of 6%
irredeemable debentures to raise $100,000 and realizes the full face value of
$100. The company falls in 40% tax bracket. Debts are issued at par.
Before tax cost of debt = Interest / Sale value or Interest /Principal being issued
at par = $6,000 / $100,000 * 100 = 6%
Cost of debt after tax = (1 - T) * Before tax cost of debt
-> (1 - 0.40) * 6% -> 0.036 or 3.6%

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Debt issued at premium or discount :Let us consider the same example with only difference is that the debentures are
issued at 10% premium.
So the Sale value or net proceeds would be = $100,000 + 10% = $110,000
Kd = I (1 - T) / SV

Where:
Kd = cost of debt after tax
SV = Sale value of debentures
T = Tax rate
I = Annual interest payment
Cost of debt = $6,000 / $110,000 * (1 - 0.40) = 3.27%
If the above debentures were issued at 10% discount, then the cost of debt
would be $6,000 / $90,000 * (1 - 0.40) = 4%.
Cost of Redeemable debt:
For redeemable debentures, the maturity date is fixed initially. The meaning
redeemable denotes that the debentures would be redeemed by the company at a
fixed date or after a specified period of notice. So, we take the average of Sale
Value and Redeemable value while calculating the cost of redeemable
debentures.

Before tax cost of Redeemable debt :Kd (before tax) = (I + [ RV - SV ] / n) divided by ( RV + SV ) / 2

Where:
I = Annual fixed interest

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RV = Redeemable Value of debenture net of commission and floatation costs, if
any. This SV would also be adjusted if issued at a discount or at a premium.
N = Term of debt till maturity

After tax cost of Redeemable debt :Kd (after tax) = Kd (before tax) * ( 1 - T )
Where:
T = tax rate
Thus,
Kd (after tax) = ((I + [ RV - SV ] / n) / (( RV + SV ) / 2)) * ( 1 - T )
Example:
Say a firm issues debentures worth $100,000 and realizes $98,000 after
allowing 2% commission to brokers. They carry an interest rate of 10% and are
due for maturity at the end of 10th year. The company has 40% tax bracket.
Redeemable value = $100,000; Sale value = $98,000.
Cost of debt (after tax) = (1 - 0.40) * (($10,000 + [$100,000 - 98,000] / 10) /
(($100,000 + 98,000) / 2))
Cost of debt (after tax) = 6.18%

COST OF PREFERENCE CAPITAL

Preference capital represents a hybrid form of financing-it partakes some
characteristics of equity and some attributes of debentures. It resembles equity
in the following ways: (1) Preference dividend is payable only out of
distributable profits. (2) Preference dividend is not an obligatory payment. (3)
Preference dividend is not a tax deductible payment.
Preference capital is similar to debentures in several ways: (1) the dividend rate
on preference capital is usually fixed. (2) The claim of preference shareholders
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is prior to the claim of equity shareholders. (3) Preference shareholders do not
normally enjoy the right to vote.
Preference shares can be divided into:
1. Irredeemable preference shares
2. Redeemable preference shares
(1) Cost of Irredeemable preference shares :Irredeemable preference shares are those shares issuing by which the company
has no obligation to pay back the principal amount of the shares during its
lifetime. The only liability of the company is to pay the annual dividends. The
cost of irredeemable preference shares is:
Kp (cost of pref. share) = Annual dividend of preference shares
Market price of the preference stock
Example: Let us calculate the cost of 10% preference capital of 10,000
preference shares whose face value is $100. The market price of the share is
currently $115.
Annual dividend = 10% of $100 = $10 per share
Kp = $10/$115 = 8.7%
(2) Cost of Redeemable preference shares:Redeemable preference shares are those shares which have a fixed maturity date
at which they would be redeemed.
Cost of Redeemable preference shares =
Annual Dividend + (Redeemable Value - Sale value) / Number of years for
redemption
(Redeemable Value + Sale value) / 2
Or
Kp = D +(RV - SV) / N
(RV + SV) / 2

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Example: A company issues 10000, 8% preference shares of $100 each
redeemable after 20 years at face value. The floatation costs are $3 per share.

Redeemable value = $100;

Sale value = $100-$3 = $97
Annual dividend = $8 per share.
Kp = 8 + (100 - 97) / 20
(100 + 97) / 2

= 8.27%

Firms may obtain equity capital in two ways

(a)retention of earnings and
(b) issue of( additional )equity shares to the public. The cost of equity or return
required by the equity share holders is the same in both the cases, since in both
cases, shareholders are providing funds to the firm to finance firms investment
proposals. Retention of earnings involves an opportunity cost. Shareholders
could receive the earnings as dividends and invest the same In alternative
investments of comparable risk to earn returns. So, irrespective of whether a
firm raises equity finance by retaining earnings or issue of additional equity
shares, the cost of equity is the same. But issue of additional equity shares to the
public involves a flotation cost whereas there is no flotation cost for retained
earnings. Hence, issue of additional equity shares to the public for raising equity
finance involves a bigger cost when compared to the retained earnings.

RETAINED EARNINGS:
Retained earnings are the most natural consequence of not distributing the
profits earned by the company among the shareholders by way of dividend. The
utilization for retained profits for meting fixed or working capital requirements
of a company is technically in the form of internal financing. Retained earnings
represent the internal sources of finance available to the company. If
depreciation charges are used for replacing worn-out equipment, retained
earnings represent the only internal source for financing expansion and growth.
Hence, retained earnings can be an important source of long term financing.
Retained earnings effectively represent infusion of additional equity in the firm.
Use of retained earnings in lieu of external equity eliminates issue costs and
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losses on account of under pricing. There is no dilution of control when a firm
relies in retained earnings. Compared to dividend income, the capital
appreciation that arises as a sequel to retained earnings is subject to lower rate
of tax. Reinvestment of profits may be convenient for many shareholders as it
relieves them to some extent of the problem of investing on their own. Retained
earnings are readily available internally. They do not require talking to
outsiders. So retained earnings are viewed very favourably by most corporate
managements.

WACC
The weighted average cost of capital (WACC) is the rate that a company is
expected to pay on average to all its security holders to finance its assets.
Weighted Average Cost of Capital. An average representing the expected return
on all of a company's securities. Each source of capital, such as stocks, bonds,
and other debt, is assigned a required rate of return, and then these required
rates of return are weighted in proportion to the share each source of capital
contributes to the company's capital structure. The resulting rate is what the firm
would use as a minimum for evaluating a capital project or investment.
The Weighted Average Cost of Capital (WACC) is used in finance to measure a
firm's cost of capital. The weighted average concept is relevant in calculating
the overall cost of capital. In financial decision making, the cost of capital
should be calculated on an after-tax basis. The following steps are involved for
calculating the firms WACC.
Calculate the cost of specific source of funds.
Multiply the cost of each source by its proportion in the capital structure.
Add the weighted components costs to get the WACC.
A calculation of a firm's cost of capital in which each category of capital is
proportionately weighted. All capital sources - common stock, preferred stock,
bonds and any other long-term debt - are included in a WACC calculation. All
else equal, the WACC of a firm increases as the beta and rate of return on equity

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increases, as an increase in WACC notes a decrease in valuation and a higher
risk.

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