Why is the after-tax cost of debt used in WACC?

• A. Taxes do not affect debt costs, so after-tax cost equals pretax cost.
• B. The after-tax cost of debt is used in WACC because it reflects tax savings and lowers the cost.
• C. Debt funding always raises the overall cost of capital.
• D. The after-tax cost of debt is used simply for ease of calculation.

Answer: (B)

The key idea is that debt isn’t costing the firm the same amount as its stated interest rate once taxes are taken into account. Interest on debt is tax-deductible, which creates a tax shield that reduces the actual expense of debt to the firm. So when you compute the company’s overall cost of capital, you use the after-tax cost of debt, which is Rd × (1 − Tc). This makes WACC reflect the true economic burden of financing with debt.

For example, if the debt rate is 6% and the corporate tax rate is 30%, the after-tax cost of debt is 6% × (1 − 0.30) = 4.2%. Using the pretax 6% would overstate the cost of debt and, in turn, inflate the WACC.

That’s why the correct approach incorporates the tax shield. The other statements aren’t accurate: taxes do affect debt costs due to the tax deduction; debt doesn’t always raise the overall cost because the tax shield can lower it; and the method isn’t chosen merely for ease of calculation.