A company raises Rs. 1,00,000 by issue of 1000, 10% debentures of Rs. 100 each at a discount of 2% redeemable after 10 years. If the corporate tax rate is 40%, what would be the cost of capital?

1. 6.82%

2. 5.98%

3. 6.18%

4. 5.5%

Before-Tax Cost Of Debt = I + [(FV - NP)/n] / (FV + NP)/2

Where, I = Interest, FV = Face Proceeds, NP = Net Proceeds, n = number of years

Interest (I)= 100 x 10% = Rs.10

Face Proceeds (FV) = Rs. 100

Net Proceeds (NP) = Face Value - Discount = 100 - 2% = Rs. 98

Number of years (n) = 10 years

Before-Tax Cost Of Debt = 10 + [(100 - 98)]/10   /  (100+98)/2 = 10 + 0.2 / 99 = 10.2/99 = 10.30%

After-Tax Cost Of Debt = Before-Tax Cost Of Debt x (1 - t)

Where, t = Tax Rate

After-Tax Cost Of Debt = 10.30 (1 - 0.40) = 6.18%

Therefore, if a company raises Rs. 1,00,000 by issue of 1000, 10% debentures of Rs. 100 each at a discount of 2% redeemable after 10 years. If the corporate tax rate is 40%,  the cost of capital will be 6.18%