ACCA Financial Management (F9) Certification Practice Exam

For irredeemable bonds with tax considerations, how is the Cost of Debt (Kd) adjusted?

1. Kd = i(1 - t) / P0

2. Kd = i / (P0 x (1 - t))

3. Kd = (i x t) / P0

4. Kd = i - t

The correct answer is: Kd = i(1 - t) / P0

The correct formulation for the Cost of Debt (Kd) in the context of irredeemable bonds considering tax effects is represented accurately in the first choice. When calculating the after-tax cost of debt for irredeemable bonds, it involves adjusting the interest rate (i) to account for the tax shield provided by the tax deductibility of interest expenses. The rationale behind the formula, Kd = i(1 - t) / P0, is as follows: 1. **Interest Rate (i)**: This is the coupon rate of the irredeemable bond, representing the annual interest payment relative to the face value. 2. **Tax Adjustment (1 - t)**: The (1 - t) factor reflects the impact of taxes, where 't' is the corporate tax rate. Since interest payments on debt are tax-deductible, the effective cost of debt is reduced, hence the adjustment. 3. **Price of the Bond (P0)**: In this context, P0 typically represents the market price of the bond. The formula accounts for how the market price influences the yield to maturity or return that investors expect from holding the bond. The combination of these factors results in an adjusted cost of debt that accurately reflects the