Question

thinking about the concept of ke and kd , which is true?

1) kd is higher than ke beacuse debt is risker than equity

2) Kd is the cost of dividends

3) kd decreases when tax rates increase

4) ke increases when stocks price rise

5) ke is lower than kd because dividends ate tax deductible

Answer 1

3)kd decreases when tax rates increase

kd (cost of debt) decreases when the tax rates increase.To prove this let's assume the before tax cost of debt =6% and tax rate =30% The after tax cost of debt will be interest rate *(1-tax rate)=.06*(1-.3)=.042 that is 4.2%

Now assume the tax rate is 40% and before ta cost of debt =6% the after tax cost of debt(kd)=.06*(1-.4)=.06*.6=.036 that is 3.6%

Thus we arrive at the conclusion that the cost of debt (Kd) decreases with an increase in tax rate

Other options explained

kd is higher than ke because debt is riskier than equity

false since ke is often higher than kd

kd is the cost of dividends

false since kd is the cost of debts

ke increases when stock prices increase

false since ke actually decreases when stock prices decreases .

ke is lower than kd since dividends are tax deductible

false dividends are not tax deductible