Corporate Finance

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Corporate Finance

Going by the above reasoning, we should not take the interest rate on non-traded debt like term loans as
cost of debt. The interest rate on comparable debt instruments is the cost of debt (or the yield on traded debt,
if the company has issued debentures). The yields on debentures issued by some well-known companies are
shown in Exhibit 4.7.

Exhibit 4.7 Prevailing yields

Yield Coupon rate
Company (percent) (percent)

IPCL 15.24 16.0
MRPL 16.03 17.5
Nirma 15.18 17.0
Tata Chemicals 10.09 12.5
Indian Rayon 15.47 16.50

Source: Business Standard, August 1998.

Assume that a company issues Rs 150 crore of bonds due in 10 years. The bond carries a coupon of
12 percent. The company’s marginal tax rate is 35 percent. Coupon on bonds is usually paid semi-annually.
The effective after-tax cost of debt is:

[1 + (0.12/2) × (1 – 0.35)]^2 = 1.0795 or 7.95 percent

The semi-annual tax shield from interest expense on these bonds (Rs crores) is:

0.35 × (0.12/2) × Rs 150 crore = Rs 3.15 crore

The present value of tax shields can be estimated by discounting semi-annual debt tax shields of Rs 3.15
crore at the pre-tax semi-annual cost of debt as the discount rate that best captures the riskiness of these tax
shields:

= 3.15 crore × PVIFA (6 percent, 10)

Cost of Preferred Stock

Preference shares share characteristics of both debt and equity. Like interest on debt, dividend on prefer-
ence shares is fixed. But preference dividends are not tax deductible, like dividends on ordinary shares.
Preference dividend is to be paid from after-tax profits.
Cost of preferred stock could be found by calculating the discount rate kp that equates current market
price and dividends and principal, similar to debentures.

P = ∑

=

+++

n

t

n

p

t

p kFkD

1

[ ]) 1( / [ / (1 ])

If the preferred stock is perpetual, the cost of preferred stock = Preference dividend per share

/ Market price of preferred stock = D / P.