Question

"Debt is considered to be the cheapest of all the sources". Identify the factor which supports this source of finance.

• A. Inflation
• B. Tax Rate
• C. Growth Prospects
• D. Financing Alternatives

Hint:

Interest on debt is tax deductible, so a higher tax rate lowers its cost.

Answer 1

The Correct Option is B

Step 1: Understanding the Question:
We need the factor that makes debt the cheapest source. The case says the interest on a loan is a tax deductible expense.

Step 2: Key Concept:
Interest paid on debt is deducted from profit before tax is worked out, so it reduces the tax bill. This lowers the effective cost of debt. The higher the tax rate, the greater the saving. Dividends on equity get no such relief.

Step 3: Check option (A).
Inflation affects the real value of money and the cost of capital in general. It is not the reason debt is cheaper than other sources. So (A) is not right.

Step 4: Check option (B).
The tax rate is the factor. Because interest is tax deductible, debt costs less after tax than equity. So (B) is right.

Step 5: Check option (C).
Growth prospects decide how much funding a firm may need and how well it can use debt. They do not make debt itself cheap. So (C) is wrong.

Step 6: Check option (D).
Financing alternatives is not a standard factor of capital structure in the syllabus, and it does not explain the low cost of debt. So (D) is wrong.

Final Answer:
Tax deductibility of interest, which depends on the tax rate, makes debt cheap. The answer is option 2. \[ \boxed{\text{Option 2}} \]