Friday, March 19, 2010

(156)---COST OF CAPITAL - COST OF EXISTING DEBT

Cost of Capital – Cost of Existing Debt

Sometime a firm may like to compute the “current” cost of its existing debt. In such a case, the cost of debt should be approximate by the current market yield of the debt.

Suppose that a firm has 11% debentures of 100000$ (100$ face value) outstanding at 31st December 20x1 to be matured on December 31st 20x6. If a new issue of debentures could be sold at a net realized price of 80$ in the beginning of 20x2, the cost of the existing debt, using short cut method, will be

Kd = (11 + 1/5 (100-80)) / (1/2 (100+80)) = 15/90 =0.167 = 16.7%

If tax rate (T) = 0.35, the after cost of debt will be:

Kd (1-T) = 0.167(1-0.35) = 0.109 = 10.9%

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