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

Which statement about the cost of debt is correct for a company paying tax at 30% on its profits, where interest is fully deductible?

Post-tax cost of debt equals the pre-tax interest rate multiplied by one minus the tax rate. Because interest is deductible, the company saves tax equal to interest times the tax rate, reducing the effective cost. For example, 10% interest at a 30% tax rate costs 7%.

  1. APost-tax cost of debt equals the pre-tax interest rate
  2. BPost-tax cost of debt equals pre-tax interest rate multiplied by (1 - tax rate)Correct
  3. CPost-tax cost of debt equals pre-tax interest rate multiplied by tax rate
  4. DPost-tax cost of debt equals pre-tax interest rate plus the tax rate

Explanation

Interest is tax deductible, so the effective cost falls by the tax shield: Kd(after tax) = Kd × (1 - t). For example, 10% interest at a 30% tax rate costs 7%. Multiplying by t gives only the tax saving, not the cost.

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