funds. From the viewpoint of capital budgeting decisions, the long term sources of funds are relevant as they constitute the major sources of financing the fixed assets. In calculating the cost of capital, therefore, the focus on long-term funds which are:- 1. Long term debt (including debentures) ii. Preference shares iii. Equity Capital iv. Retained Earnings +48 The calculation of the cost of debt is relatively easy. A debt may be in the form of Bond or Debenture. A Bond is a long term debt instrument or security. Bonds are issued by the government. Therefore, they do not have any risk of default. The government honours obligations on its Bonds. Bonds of the public sector companies in India are generally secured, but they are not free from the risk of default. The private sector companies also issue bonds, which are called as Debentures in India. A company in India can issue secured or unsecured debentures. 5.4.1 COST OF DEBENTURES The cost of debentures and long term loans is the contractual interest rate adjusted further for the tax liability of the company. For a company, the higher the interest charges, the lower the amount of tax payable by the company. The interest on debentures or bonds is debited to the profit and loss account. Therefore, the taxable profit of the company is reduced. It is an indirect saving to the company. Therefore the cost of debt capital is reduced to the extent of the tax liability Illustration 1: Two companies X and Y are having their capital structure as follows; Company X Company Y Earnings before interest and taxes (EBIT) 100 100 (Rs. In lakhs) Interest () (12%) 40 Profit before tax (PBT) 100 60 Tax (T) 35% 21% Profit after Tax (PAT) 65 39 The tax rate applicable to the company is 35 percent