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

Which statement best explains why, in most corporate finance analysis, the after-tax cost of debt is lower than the pre-tax cost of debt for a profitable Indian company?

The after-tax cost of debt is lower because interest is deductible when computing taxable profit. The tax saved on interest offsets part of the payment, so the effective cost equals the pre-tax rate multiplied by one minus the tax rate, whereas dividends receive no such deduction.

  1. ALenders accept a lower coupon from companies that pay tax
  2. BInterest payments are deductible in computing taxable profit, so the tax saved reduces the effective costCorrect
  3. CDebt holders receive a share of the company's tax refund
  4. DInterest is paid out of retained earnings rather than profits
  5. Debt is always issued at a discount to face value

Explanation

Interest is a tax-deductible expense, so each rupee of interest reduces tax by the tax rate. The effective cost is therefore the pre-tax rate multiplied by (1 - tax rate). Dividends, by contrast, are not deductible.

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