Neha Ltd. borrows at 10% p.a. Interest is a deductible expense. Last year its tax rate was 30%, and its after-tax cost of debt was 7%. This year the tax rate applicable to it falls to 20%.
What is its after-tax cost of debt this year?
Answer & explanation
Correct answer: option 3
The correct answer is Option (3) → 8%
Given:
Rate of interest = 10% p.a.
Tax rate this year = 20%
After-tax cost of debt = Rate of interest − Tax saved on it
Tax saved = 20% of 10% = 2%
After-tax cost of debt = 10% − 2% = 8%
A lower tax rate gives a smaller tax saving, so debt now costs more than last year’s 7%.
Option (1) 2% — Incorrect. This is the tax saving.
Option (2) 7% — Incorrect. This is last year’s cost at the 30% tax rate: 10% − 3%.
Option (4) 10% — Incorrect. This ignores that interest is a deductible expense.
NCERT (2026-27 Edition): “6. Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax rate. The firms in our examples are borrowing @ 10%. Since the tax rate is 30%, the after tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.” |