Question

Which of the following statements is TRUE?

A) The after-tax cost of equity is less than the before-tax cost of equity for a corporation with a tax rate greater than 0.00%

B) The after-tax cost of debt is less than the before-tax cost of debt for a corporation with a tax rate greater than 0.00%

C) The after-tax cost of preferred shares is less than the before-tax cost of preferred shares for a corporation with a tax rate greater than 0.00&

D) None of the above

Answer 1

ANSWER

CORRECT ANSWER Option (B)

EXPLANATION

• The Tax Rate imapcts only the "Cost of Debt" as the Cost of Debt {ie. Interest Cost} is a "TAX DEDUCTABLE EXPENSE" which means we get a Tax Shied on the amount of Interest we pay on our Borrowed Debt.
• The Other two Costs {ie. Cost of Preferred Stock and Cost of Equity} does not have any Tax Advantage as these are Profit & Loss Appropriation Items.
• Hence Option (A) and Option (C) are TOTALLY FALSE.
• Now when we talk about "Cost of Debt", our "After-Tax Cost of Debt" is LOWER THAN the "Before-Tax Cost" beacuse of the "Tax Shield" that we get on the Interest Payment. So this Amount of Tax Shield REDUCES OUR COST OF DEBT.