Cost of Perpetual and Redeemable Debt

Cost of Irredeemable Debt or Perpetual Debt:

Irredeemable debt is that debt which is not required to be repaid during the lifetime of the company. Such debt carries a coupon rate of interest. This coupon rate of interest represents the before tax cost of debt. After tax cost of perpetual debt can be calculated by adjusting the corporate tax with the before tax cost of capital. The debt may be issued at par, at discount or at premium. The cost of debt is the yield on debt adjusted by tax rate.

Symbolically, cost of perpetual debt (Kd) can be calculated using the following formula:

Cost of irredeemable debt (Kd) = I/NP (1 – t)

Where:

I = Annual interest payment,

NP = Net proceeds from issue of debenture or bond, and

t = Tax rate.

Cost of Irredeemable Preference Share:

Irredeemable preference share is not required to be repaid during the lifetime of the company. Such preference shares carry a rate of dividend, which is the cost of irredeemable preference shares. Since the shares may be issued at par, at premium or at a discount, the cost of preference shares is the yield on preference shares. Cost of irredeemable preference shares is calculated by using the following formula:

KP = DP/NP

Where:

DP = Preference dividend and

NP = Net proceeds from issue of preference shares.

Cost of Redeemable Preference Shares:

Redeemable preference shares are those that are repaid after a specific period of time. Hence while calculating the cost of redeemable preference shares, the period of preference shares and redeemable value of the preference shares must be given due consid­eration.

Like irredeemable preference shares, redeemable preference shares may also be issued at par, discount or at a premium. Moreover, there may be floatation costs. So, to calculate net proceeds, adjust­ment for floatation cost is necessary. Since it is redeemable the redeemable value may differ from its face value depending on whether the preference shares are redeemed at par, discount or at premium.

The cost of redeemable preference share can be calculated by using the following formula:

Kp = {Dp + 1/n (RV-NP)}/ {1/n (RV+NP)}

Where:

Dp = Preference dividend,

n = Period of preference share,

RV = Redeemable value of preference share, and

NP = Net proceeds from issue of preference shares.