If corporate tax rate Tc increases while debt remains the same, what happens to the after-tax cost of debt in WACC?

• A. It increases
• B. It decreases
• C. It stays the same
• D. It becomes unpredictable

Answer: (B)

Taxes create a shield on debt: the after-tax cost of debt is the interest rate on debt times (1 minus the corporate tax rate). So, after-tax cost of debt = Rd × (1 − Tc). If the corporate tax rate Tc rises while the amount of debt and the pre-tax cost of debt Rd stay the same, the factor (1 − Tc) becomes smaller. That lowers the amount the firm actually pays after tax for each dollar of debt, so the after-tax cost of debt decreases. Since WACC uses the after-tax cost of debt, a higher Tc with the same debt level reduces the debt portion of WACC as well. For example, with Rd at 6%, a tax rate moving from 30% to 40% cuts the after-tax cost from 4.2% to 3.6%.