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In the Cost of Debt formula, the tax-shield (1 − t) is applied because:
ATax is a fixed expense
BTax rate is constant
CInterest paid is allowed as a deductible expense for corporate tax
DInterest is not paid in cash
Answer & Solution
Correct answer: C. Interest paid is allowed as a deductible expense for corporate tax
1. Interest paid on debt is tax-deductible.
2. Saving in tax liability = Interest × tax rate.
3. Effective cost of debt is reduced by the tax shield, hence the (1 − t) multiplier.
_Source: ICAI BoS CA Inter Paper 6A, Ch 4 "Cost of Capital", §5.1(v)_
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