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BRILLIANT’S Cost of Capital 307

debt securities, such as its bonds. The cost of g§^m{dV eo¶ahmoëS>g© àmßV H$aZm MmhVm h¡& S>oãQ> H$s
debt has two basic components: one is the H$m°ñQ> Ho$ Xmo ‘w»¶ H$ånmoZoÝQ> hmoVo h¢ nhbm dm{f©H$ BÝQ>aoñQ>
annual interest and the other arises from the VWm Xÿgam O~ S>oãQ> nhbr ~ma Bí¶y {H$¶m OmVm h¡ V~
amortization of discounts or premium paid or CgHo$ {S>ñH$mCÝQ> ¶m àr{‘¶‘ Ho$ ^wJVmZ AWdm àmpßV H$s
received when the debt is initially issued. CYma MwH$mB© go CËnÝZ hmoVm h¡&
Since, the interest payments and the BÝdoñQ>g© H$s [a³dm¶S>© aoQ> Am°’$ [aQ>Z© ‘| n[adV©Z go
return of principal remain constant regardless à^m{dV hþE {~Zm BÝQ>aoñQ> no‘|Q> VWm qà{gnb na [aQ>Z©
of the change in investors required rate of pñWa ahVm h¡, Ho$db ~m°ÊS> àmBO VWm S>oãQ> H$s H$m°ñQ>
return, only the bond price and the cost of debt
can change. A financial manager can pinpoint n[ad{V©V hmo gH$Vr h¡& OZabmBO B³doeZ ‘| K H¡$ëHw$boQ>
i
the exact cost of debt after the price change by H$aZo na ’$m¶Zo{e¶b ‘¡ZoOa àmBO ‘| M|Oog Ho$ ~mX S>oãQ>
calculating K in generalized equation: H$s E³Oo³Q> H$m°ñQ> kmV H$a gH$Vm h¡&
i
I
K =
i NP
Where, I = Interest
NP = Net Price (after adjusting, discount and floatation cost)
Since, interest is a tax deductible expense, My§{H$, BÝQ>aoñQ> EH$ Q>¡³g {S>S>³Q>o~b E³gnoÝg h¡,
we have to consider the after-tax cost of debt, AV: h‘§o AmâQ>a Q>¡³g H$m°ñQ> Am°’$ S>oãQ²>g H§$grS>a H$aZm
especially if we want to judge its impact on the hmoJm, {deof ê$n go ¶{X h‘| ’$‘© H$s AmâQ>a Q>¡³g
firm's after-tax profitability or compare it to àm°{’$Q>o{~{bQ>r na BgHo$ à^md H$mo Om§MZm hmo ¶m CZ {d{^ÝZ
the cost of other types of securities which a àH$ma H$s {g³¶y[aQ>rO H$s H$m°ñQ> H$mo Bggo H$åno¶a H$aZm
company can offer whose cash flows streams hmo {Ogo dh H$ånZr Am°’$a H$a gH$Vr h¡ {OZH$s H¡$e âbmo
are not deductible, such as preference and ñQ´>r‘ Q>¡³g {S>S>³Q>o~b Zht hmoVr h¢ O¡go {à’$a|g eo¶g©
equity shares. We can calculate the after-tax VWm Bp³dQ>r eo¶g©& Am°âQ>a Q>¡³g H$m°ñQ> Am°’$ S>oãQ> H$mo
cost of debt by adjusting the pre-tax cost of kmV H$aZo Ho$ {bE Q>¡³g aoQ> Ho$ {bE àr-Q>¡³g H$mo Bg
debt for the tax rate such that: àH$ma ES>OñQ> {H$¶m OmVm h¡ {H$:
K = K (1 – t)
d i
Where, K = the after-tax cost of debt
d
K = the pre-tax cost of debt
i
t = the tax rate.

Illustration 4.1.1
A company has 15% perpetual debt of ` 1,00,000. The tax rate is 50%. Determine the cost of
capital (before tax as well as after tax) assuming the debt is issued at (i) par (ii) 10% discount and
(iii) 10% premium.
EH$ H§$nZr H$m ` 1,00,000 H$m 15% nanoMwAb S>oãQ> h¡& Q>¡³g aoQ> 50% h¡& H¡${nQ>b H$s H$m°ñQ> (Q>¡³g Ho$ nhbo
VWm Q>¡³g Ho$ níMmV²) H$m {ZYm©aU H$s{OE ‘mZm {H$ S>oãQ> (i) nma (ii) 10% {S>ñH$mC§Q> VWm (iii) 10% [à{‘¶‘ na Omar
{H$¶m J¶m h¡&