A company issued 10,000, 10% debentures of` 100 each at a premium of 10% on1.4.2017 to be matured on 1.4.2022. The debentures will be redeemed on maturity.COMPUTE the cost of debentures assuming 35% as tax rate.© The Institute of Chartered Accountants of India
Question
A company issued 10,000, 10% debentures of` 100 each at a premium of 10% on1.4.2017 to be matured on 1.4.2022. The debentures will be redeemed on maturity.COMPUTE the cost of debentures assuming 35% as tax rate.© The Institute of Chartered Accountants of India
Solution
To calculate the cost of debentures, we need to consider the net proceeds from the issue, the redemption value, and the interest expense (after tax). Here's how to do it:
Step 1: Calculate the net proceeds from the issue of debentures. The company issued 10,000 debentures at a premium of 10%. So, the issue price per debenture is 100 + 10% of 100 = 110. Therefore, the total proceeds from the issue are 10,000 * 110 = 1,100,000.
Step 2: Calculate the redemption value. The debentures will be redeemed at their face value, which is 100. So, the total redemption value is 10,000 * 100 = 1,000,000.
Step 3: Calculate the annual interest expense (after tax). The annual interest on the debentures is 10% of the face value, which is 10% of 100 = 10. So, the total annual interest is 10,000 * 10 = 100,000. However, this interest is tax-deductible. So, the after-tax interest expense is 100,000 * (1 - 35%) = 65,000.
Step 4: Calculate the cost of debentures. The cost of debentures is the annual interest expense (after tax) plus the annual amortization of the premium (or discount) on issue (or redemption). In this case, the premium on issue is the difference between the net proceeds and the redemption value, which is 1,100,000 - 1,000,000 = 100,000. This premium is amortized over the life of the debentures, which is 5 years. So, the annual amortization is 100,000 / 5 = 20,000. Therefore, the cost of debentures is 65,000 + 20,000 = 85,000.
So, the cost of debentures is 85,000.
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