IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company
Aravali Power Ltd has Rs 50 crore of 9% debentures outstanding. The corporate tax rate is 25%. Ignoring issue costs, what is the post-tax cost of this debt if the debentures are issued and redeemed at par?
The post-tax cost of debt is 6.75%. With issue and redemption at par, the pre-tax cost equals the 9% coupon, and because interest is tax deductible at 25%, the effective cost is 9% multiplied by 0.75.
- A9.00%
- B6.75%Correct
- C11.25%
- D2.25%
- 16.75%
Explanation
Debt at par has a pre-tax cost equal to its coupon, 9%. Interest is tax deductible, so the post-tax cost is 9% x (1 - 0.25) = 6.75%. Option 9.00% ignores the tax shield, and 11.25% divides by 0.8 instead of multiplying by 0.75.
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