Question 18.5: The Indian subsidiary of an American MNC has raised Rs 50 mi......

Cost of debt is determined by solving the following equation:
\qquad \qquad CI_0=\sum\limits_{t=1}^{8}{\frac{COI_t}{(1+k_d)^t} +\frac{COP_8}{(1+k_d)^8}}
Where COI = Cash outflow of interest in years 1–8, duly adjusted for tax advantage, i.e., (Rs 50 million × 0.12 × 0.65) = Rs 3.9 million.
\quad COP_8  = Principal repayment in the year of maturity (t = 8) i.e., Rs 50 million + 4 per cent premium, i.e., Rs 2 million less tax advantage (Rs 2 million × 0.35) = Rs 0.70 million = Rs 51.3 million.
\,  CI_0 = Effective cash inflows/proceeds duly adjusted for flotation cost and tax shield on it as shown below:
\,  Therefore, Rs 49.35 million =\sum\limits_{t=1}^{8}{\frac{\mathrm{Rs \>3.9 \>million}}{(1+k_d)^t} +\frac{\mathrm{Rs \>51.3 \>million}}{(1+k_d)^8}}
\quad k_d has two elements: (i) the after-tax cost of interest, i.e., 12 per cent (1 – 0.35) = 7.8 per cent and (ii) flotation costs in raising funds and payment of premium on redemption of debentures, that is, Rs 51.3 million – Rs 49.35 million = Rs 1.95 million. Evidently, kd is to be higher than 7.8 per cent to take note of such costs.
\,  While it is true that the determination of kd involves a trial and error process, it is not difficult. In the present context, the kd is to be 7.8 per cent plus. For calculating how much that would be the rule is simple, Rs 1.95 million (Rs 51.3 million – Rs 49.35 million) is the cost of the Rs 49.35 million funds that have been raised. It yields 4 per cent effective flotation cost. This 4 per cent is to be spread over in 8 years, which approximately leads to 0.5 per cent share of each year. As a result, the k_\mathrm{d} is to be 7.8 per cent + 0.5 per cent = 8.3 per cent. Accordingly, its precise value can be computed by interpolating two rates of discount, namely, 8 per cent and 9 per cent.
\qquad \qquad k_d = 8% + \left\lgroup\frac{\mathrm{Rs \>50.11 \>million −Rs\> 49.35 = 0.76\> million}}{\mathrm{Rs \>50.11 \>million −Rs\> 47.34 = 2.77\> million}} \right\rgroup = 8.27%
\,  In case the subsidiary raises funds from the international finance markets and not from the host country where it is located, the k_d  computation requires adjustment for variation in foreign exchange rates. In specific terms, the cash outflows exercise should take into account the value of foreign currency (in which borrowings are made) with reference to the currency of the host country (known as the base currency). The concept is illustrated in Example 18.6.