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

Which one of the following is generally the cheapest source of long-term finance for a profitable Indian company, when the nominal rates of interest/return promised to each type of investor are identical?

Debentures are the cheapest source because interest is deductible for tax, so the effective post-tax cost is the rate multiplied by one minus the tax rate. Dividends on preference and equity shares, and the return on retained earnings, get no tax shield.

  1. AEquity share capital
  2. BPreference share capital
  3. CRetained earnings
  4. DDebenturesCorrect

Explanation

Interest on debentures is a tax-deductible expense, so the post-tax cost is Kd(1 - t), which is lower than the stated rate. Dividends on preference and equity shares are paid out of post-tax profits and give no tax shield. Hence, at the same nominal rate, debentures cost least.

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