Given below are two statements:
Assertion (A): The after-tax cost of debt for a firm is lower than the rate of interest it pays on the debt.
Reason (R): The cost of debt is lower than the cost of equity, as the lender’s risk is lower than the equity shareholder’s risk.
In the light of the above statements, choose the correct answer from the options given below:
Answer & explanation
Correct answer: option 2
The correct answer is Option (2) → Both (A) and (R) are true but (R) is not the correct explanation of (A).
Assertion (A): The after-tax cost of debt for a firm is lower than the rate of interest it pays on the debt. — True. Interest is a deductible expense, so it lowers the tax a firm pays. At 10% interest and 30% tax, the after-tax cost of debt is only 7%.
Reason (R): The cost of debt is lower than the cost of equity, as the lender’s risk is lower than the equity shareholder’s risk. — True. The lender gets an assured return and repayment of capital. As the lender’s risk is lower, the lender asks for a lower return than equity shareholders do.
Why R does not explain A?
A compares the cost of debt before and after tax. R compares debt with equity. The lender’s lower risk explains why the interest rate is low, but it does not explain why the cost falls further after tax.
The correct reason for A is that interest is a deductible expense. Because interest reduces taxable profit, part of it comes back as tax saved, so the after-tax cost is below the rate paid.
NCERT (2026-27 Edition): “Capital Structure … Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. …” “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.” |