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CA Intermediate · Financial Management and Strategic Management · Cost of Capital

Kaveri Industries Ltd has 12% irredeemable debentures of Rs 1,000 face value issued at par. Floatation cost is nil and the tax rate is 25%. What is the after-tax cost of debt, and what is the main reason it is lower than the pre-tax cost?

The after-tax cost of debt is 9%, computed as 12% x (1 - 0.25). It is lower than the 12% pre-tax cost because interest on debentures is a tax-deductible expense, which creates a tax shield for the company.

  1. A12%, because interest is paid before dividends
  2. B9%, because interest is tax deductibleCorrect
  3. C9%, because debentures are issued at par
  4. D15%, because tax raises the effective cost

Explanation

Kd after tax = 12% x (1 - 0.25) = 9%. The reduction occurs because interest is an allowable expense that reduces taxable profit. Issue at par does not by itself reduce the cost, so option C gives the wrong reason.

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