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CS Executive · Corporate Accounting and Financial Management · Cost of Capital

Which statement about the cost of debt in a company's cost of capital computation is correct?

Cost of debt is normally measured after tax, because interest is a deductible expense and reduces the company's tax bill. This makes the effective cost lower than the coupon rate, unlike equity or preference dividends, which are not deductible.

  1. AThe tax shield on interest raises the cost of debt above the coupon rate
  2. BCost of debt is normally computed after tax because interest is a deductible expenseCorrect
  3. CCost of debt is always equal to the dividend yield on equity
  4. DPreference dividend is treated as tax deductible, so it is added to debt cost

Explanation

Interest is allowed as a deduction, so the effective cost to the firm is Kd(1 − t), which is lower than the coupon. The other statements reverse the effect of the tax shield or confuse debt with equity or preference capital.

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