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

Which statement about the cost of debt is correct in capital cost theory taught for financial management?

The correct statement is that the cost of debt is reduced by the tax shield, because interest is a deductible expense. The after-tax cost equals the pre-tax rate times one minus the tax rate, so a higher tax rate lowers the effective cost of debt.

  1. ACost of debt is always higher than cost of equity because creditors bear more risk
  2. BCost of debt is reduced by the tax shield because interest is a deductible expenseCorrect
  3. CCost of debt is calculated on the book value of retained earnings
  4. DCost of debt rises when the company's tax rate rises

Explanation

Interest is deductible in computing taxable profit, so the effective cost is Kd(1 - t). Debt holders bear less risk than equity holders, so debt is usually cheaper. A higher tax rate lowers, not raises, the after-tax cost.

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