The impact of tax rate on cost of debt is:
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → A higher tax rate makes debt relatively cheaper
Option (1) A higher tax rate makes debt relatively cheaper — Correct. Interest on debt is a deductible expense, so it reduces the tax a company pays. If a company borrows at 10% and the tax rate is 30%, the real cost of debt after tax is only 7%. The higher the tax rate, the more tax is saved, and the cheaper debt becomes compared with equity.
Option (2) A higher tax rate makes debt relatively more costlier — Incorrect. The effect is reversed. A higher tax rate saves more tax on interest, so debt becomes cheaper, not costlier.
Option (3) A higher or lower tax rate doesn't have any impact on debt — Incorrect. Because interest is deducted before tax, the tax rate does change the real cost of debt.
Option (4) A lower tax rate makes debt relatively cheaper — Incorrect. A lower tax rate saves less tax on interest, so debt becomes relatively costlier.
NCERT (2026-27 Edition): “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.” |