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CS Executive · Corporate Accounting and Financial Management · Cost of Capital

Kaveri Ltd. issues 1,000 perpetual debentures of Rs 100 each at a 10% coupon, sold at Rs 90 per debenture with no other costs. The tax rate is 30%. Using the perpetual debt formula Kd = I(1 - t)/Net proceeds, what is the after-tax cost of debt (rounded to one decimal)?

The after-tax cost of debt is about 7.8%. Annual interest is Rs 10, which becomes Rs 7 after 30% tax, and this is divided by the net issue proceeds of Rs 90, not the face value of Rs 100. Using Rs 100 would wrongly give 7.0%.

  1. A7.0%
  2. B11.1%
  3. C7.8%Correct
  4. D10.0%

Explanation

Annual interest on each debenture = 10% x 100 = Rs 10. After tax = 10 x 0.70 = Rs 7. Net proceeds = Rs 90. Kd = 7/90 = 7.78%, i.e. about 7.8%. Using face value as the base gives 7.0%, the wrong base. Pre-tax 10/90 = 11.1% ignores the tax shield.

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