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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

Which of the following best explains why, for a profitable company, the cost of debt used in the WACC is normally taken after tax?

The cost of debt is taken after tax because interest is deductible when computing taxable profit. Each rupee of interest reduces the tax bill, so the company's effective cost is the pre-tax rate multiplied by one minus the tax rate, for a company that pays tax.

  1. AInterest payments are deductible in computing taxable profit, so the effective cost to the company is lower than the coupon rateCorrect
  2. BDebt holders pay tax on interest, so the company receives a refund of that amount
  3. CDebt is always issued at a discount to its nominal value, which lowers its cost
  4. DEquity holders require a lower return when debt is present, so debt cost is reduced
  5. Tax law requires all financing costs to be shown net of tax in the accounts

Explanation

Interest is a tax-deductible expense, so each rupee of interest saves tax at the corporate rate. The effective cost is therefore cost of debt x (1 - tax rate). The other options misdescribe who bears tax or confuse this with discount issue or accounting presentation.

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