Skip to content

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

A profitable Indian company is choosing between financing a new plant with debt or with new equity shares. Interest on the debt is an allowable expense in computing taxable profit, but dividends are paid out of post-tax profit. Which statement best describes the effect of this tax treatment?

The tax treatment lowers the effective cost of debt relative to equity. Interest is deductible in computing taxable profit, so it creates a tax saving, while dividends are paid from profit after tax and give no relief. This tilts the financing choice towards debt.

  1. AIt lowers the effective cost of debt relative to equity, because interest reduces the tax billCorrect
  2. BIt raises the effective cost of debt, because interest income is taxed in the company's hands
  3. CIt makes debt and equity equally costly after tax, because both are tax deductible
  4. DIt lowers the cost of equity, because dividends reduce the tax payable by the company
  5. It has no effect on financing choice, because tax is paid by shareholders only

Explanation

Interest is deducted before tax, so the company saves tax at its marginal rate on each rupee of interest. Dividends are an appropriation of post-tax profit and give no such saving. The after-tax cost of debt is therefore lower than the pre-tax rate.

Did you get it right without looking?

One question tells you little. A timed set on Personal and corporate taxation shows your real accuracy, how long you take and where you lose marks.

Practise Personal and corporate taxationFree diagnostic mock

More Personal and corporate taxation questions