CS Executive · Corporate Accounting and Financial Management · Cost of Capital
Meera Ltd. has Rs 50 lakh of 8% debentures issued at par. The tax rate is 25% and the company has no flotation cost. Next year the tax rate falls to 20% while the coupon remains the same. By how many percentage points does the after-tax cost of debt change?
The after-tax cost of debt rises by 0.4 percentage points. It was 6.0% at a 25% tax rate and becomes 6.4% at a 20% tax rate, because a lower tax rate reduces the value of the interest tax shield.
- AFalls by 0.4
- BRises by 0.4Correct
- CRises by 0.8
- DFalls by 0.8
Explanation
Earlier Kd = 8% x 0.75 = 6.0%. New Kd = 8% x 0.80 = 6.4%. The after-tax cost rises by 0.4 percentage points because the tax shield shrinks. Falling options reverse the direction; 0.8 confuses the 5-point tax change with the full coupon effect.
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