In the WACC formula, how does the tax rate affect the after-tax cost of debt?

In the WACC formula, how does the tax rate affect the after-tax cost of debt?

• A. The after-tax cost of debt is Cost of Debt × (1 - Tax Rate)
• B. The after-tax cost of debt is Cost of Debt × (1 + Tax Rate)
• C. The after-tax cost of debt is Cost of Debt
• D. Tax rate has no effect on debt cost

Answer: (A)

Interest expense is tax-deductible, so the cost of debt to the company is reduced by the tax shield. In the WACC framework, the after-tax cost of debt is the pre-tax cost of debt multiplied by (1 minus the tax rate). This reflects that only the net cost remains after taxes are saved through interest deductions. For example, with a debt cost of 6% and a 30% tax rate, the after-tax cost becomes 6% × (1 − 0.30) = 4.2%. The other options imply the cost rises with taxes, stays unchanged, or ignores taxes, which isn’t consistent with how tax-deductible interest lowers net borrowing costs.

Interest expense is tax-deductible, so the cost of debt to the company is reduced by the tax shield. In the WACC framework, the after-tax cost of debt is the pre-tax cost of debt multiplied by (1 minus the tax rate). This reflects that only the net cost remains after taxes are saved through interest deductions. For example, with a debt cost of 6% and a 30% tax rate, the after-tax cost becomes 6% × (1 − 0.30) = 4.2%. The other options imply the cost rises with taxes, stays unchanged, or ignores taxes, which isn’t consistent with how tax-deductible interest lowers net borrowing costs.