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CMA Intermediate · Financial Management and Business Data Analytics · Sources of Finance

Kaveri Ltd has 10% debentures of Rs. 50,00,000 outstanding. The tax rate is 25%. The debentures are issued and redeemable at par with no flotation cost. What is the after-tax cost of this debt?

The after-tax cost of debt is 7.5%. Because debentures are issued and redeemed at par with no flotation cost, the cost equals the coupon of 10% multiplied by one minus the 25% tax rate, giving 7.5%.

  1. A10%
  2. B2.5%
  3. C7.5%Correct
  4. D12.5%

Explanation

Interest = 10% of 50,00,000 = Rs. 5,00,000. Tax saving = 25% of 5,00,000 = Rs. 1,25,000. After-tax interest = Rs. 3,75,000, which is 7.5% of Rs. 50,00,000. Equivalent: 10% x (1 - 0.25) = 7.5%. Choosing 10% ignores the tax shield.

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