CS Executive · Corporate Accounting and Financial Management · Cost of Capital
Ananya Textiles raised Rs 10,00,000 through 12% debentures issued and redeemable at par. The tax rate is 25% and flotation costs are nil. What is the post-tax cost of this debt?
The post-tax cost of the debentures is 9 percent. Interest of 12 percent is tax deductible, so the effective cost is 12 multiplied by one minus 0.25, which equals 9 percent. Ignoring the tax shield would wrongly give 12 percent.
- A12%
- B9%Correct
- C16%
- D3%
Explanation
Post-tax cost of debt = interest rate x (1 - tax rate) = 12% x (1 - 0.25) = 9%. Option 12% ignores the tax shield on interest. Option 16% divides by (1 - t) instead of multiplying, which is the wrong direction. Option 3% subtracts the tax rate from interest rate by mistake.
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