Skip to content

IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

A company is financed by equity and by debt on which it pays interest and receives tax relief. Which statement best explains why the after-tax cost of debt is normally below the pre-tax cost?

The after-tax cost of debt is lower because interest is deductible in computing taxable profit. The tax saved on each rupee of interest reduces the net cost to the company, giving pre-tax cost multiplied by one minus the tax rate.

  1. AInterest payments are deductible when computing taxable profit, so the tax saved reduces the effective costCorrect
  2. BDebt holders accept lower returns because they rank ahead of shareholders in a winding up
  3. CDividends are taxed at a higher rate than interest in the hands of investors
  4. DDebt is always issued at a discount to its nominal value
  5. Interest is paid before the financial year end so it is not counted as a cost

Explanation

Interest is a tax-deductible expense, so each rupee of interest saves tax at the corporate rate. The effective cost is therefore pre-tax cost x (1 - tax rate). Seniority in liquidation affects the pre-tax cost, not the tax adjustment.

Did you get it right without looking?

One question tells you little. A timed set on Capital structure and dividend policy shows your real accuracy, how long you take and where you lose marks.

Practise Capital structure and dividend policyFree diagnostic mock

More Capital structure and dividend policy questions