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IAI Actuarial Core Principles · Business Finance · Personal and corporate taxation

A company in India that is taxed on its profits can deduct interest on its borrowings when computing taxable profit, whereas dividends paid to shareholders are paid out of profit after tax. What is the main consequence of this difference for the choice between debt and equity financing?

Tax favours debt because interest is deductible in computing taxable profit, which reduces the company's tax bill and lowers the after-tax cost of borrowing below the stated interest rate. Dividends are paid from post-tax profit and give no equivalent relief.

  1. ADebt has a lower after-tax cost than its pre-tax cost, so tax favours debt financingCorrect
  2. BEquity has a lower after-tax cost than its pre-tax cost, so tax favours equity financing
  3. CDebt and equity have identical after-tax costs, so tax is irrelevant to financing
  4. DDebt becomes more expensive after tax because interest is deductible
  5. Dividends create a tax shield that exceeds the interest tax shield

Explanation

Interest reduces taxable profit, so the company saves tax equal to interest times the tax rate. This makes the after-tax cost of debt lower than the pre-tax cost. Dividends get no such deduction, so equity gets no shield.

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