Gupta Ltd. pays interest of Rs. 5 lakh on its debentures. Its tax rate is 30%, and interest is a deductible expense.
What is the cost of this interest to the company after taking the tax saving into account?
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Rs. 3.5 lakh
Given:
Interest = Rs. 5 lakh
Tax rate = 30%
Cost after tax = Interest − Tax saved on it
Tax saved = 30% of Rs. 5 lakh = Rs. 1.5 lakh
Cost after tax = 5 − 1.5 = Rs. 3.5 lakh
Interest is deducted before tax is worked out, so the company pays Rs. 1.5 lakh less tax.
Option (1) Rs. 1.5 lakh — Incorrect. This is the tax saving itself.
Option (3) Rs. 5 lakh — Incorrect. This leaves out the tax saving, as if interest were not deductible.
Option (4) Rs. 6.5 lakh — Incorrect. This adds the tax saving to the interest: 5 + 1.5.
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.” |