Question

When calculating the cost of capital of the components of a firm's capital structure, the company tax rate is important to which of the following component(s)? (please explain thoroughly)
(a) Ordinary shares
(b) Debt
(c) Preference shares
(d) Non-current assets

Answer 1

When calculating the cost of capital, the company tax rate is important to (B) Debt

When we are calculating the cost of debt financing, we will deduct the tax rate from the interest rate of debt to come at the actual cost of debt, i.e

Cost of debt financing = interest rate (1 - tax rate)

Hence, the tax is a deduction which reduces the effective cost of debt and eventually the cost of capital. Interest is first paid to debtholders and then taxes are deducted. Hence, while calculating the cost of capital of the component of a firm's capital structure, the company tax rate is important to debt.

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