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CS Executive · Corporate Accounting and Financial Management · Cost of Capital

A company has 12% debentures of ₹1,00,000 outstanding, trading at par, with a tax rate of 25%. If the tax rate rises to 30%, what happens to the after-tax cost of debt?

The after-tax cost of debt falls from 9.0% to 8.4%. A higher tax rate increases the value of the interest tax shield, so the effective cost, 12% times one minus the tax rate, declines from 12×0.75 to 12×0.70.

  1. AFalls from 9.0% to 8.4%Correct
  2. BRises from 8.4% to 9.0%
  3. CRemains at 12%
  4. DFalls from 12% to 8.4%

Explanation

At 25%, Kd = 12 × 0.75 = 9.0%. At 30%, Kd = 12 × 0.70 = 8.4%. A higher tax rate increases the shield, so the cost falls. The option showing a rise reverses the direction of the effect.

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