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CMA Intermediate · Financial Management and Business Data Analytics · Cost of Capital

Himalaya Pharma has Rs 50 lakh of 12% term loan and Rs 50 lakh of 10% debentures issued at par, both irredeemable. Tax rate is 25%. The company expects to use the weighted cost of its debt for a project. What is the weighted average after-tax cost of debt, and what happens if the tax rate falls to zero for the year due to losses?

The weighted after-tax cost is 8.25%, from a pre-tax average of 11% reduced by a 25% tax shield. If losses mean no tax is payable, the interest gives no tax saving and the effective cost of debt rises to the full 11%.

  1. A8.25% after tax; cost rises to 11% with no tax shieldCorrect
  2. B8.25% after tax; cost stays at 8.25%
  3. C8.25% after tax; cost rises to 11%, but the carried-forward loss still gives full current shield
  4. D9.00% after tax; cost rises to 11%

Explanation

Pre-tax weighted cost = (12% + 10%)/2 = 11%. After tax = 11% x 0.75 = 8.25%. If the firm has no taxable profit, interest gives no current tax saving, so effective cost equals the pre-tax 11%. The other options misstate the shield or the arithmetic.

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