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CA Intermediate · Financial Management and Strategic Management · Types of Financing

Rohan Engineering needs to finance a machine costing ₹10,00,000. Option A: a bank loan at 12% p.a. with interest tax-deductible, and the firm's tax rate is 25%. Option B: a finance lease with annual rentals of ₹2,40,000 for 5 years, payable at the year end, also tax-deductible. Under Option A, the after-tax cost of the loan is closest to which figure, and what is the key reason it differs from the pre-tax rate?

The after-tax cost of the loan is 9%. Interest is a tax-deductible expense, so the firm saves tax at 25% on the interest paid, and the effective cost is 12% multiplied by (1 minus 0.25). The pre-tax rate overstates the true cost.

  1. A12%, because interest is not allowed as a deduction
  2. B9%, because the interest tax shield reduces the effective cost by the tax rateCorrect
  3. C3%, because tax is charged on the interest saved
  4. D15%, because tax adds to the cost of borrowing

Explanation

After-tax cost of debt = 12% x (1 - 0.25) = 9%. Interest is deductible, so each rupee of interest saves 25 paise in tax. The 12% option ignores the shield, 3% is just the tax saving (12 x 0.25), and 15% wrongly adds tax.

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