How does the tax rate affect the cost of debt in WACC?

The cost of debt in the context of the Weighted Average Cost of Capital (WACC) is influenced by the tax rate primarily because interest expenses on debt are typically tax-deductible. This means that the effective cost of borrowing is reduced by the amount of taxes saved due to this deduction.

When calculating WACC, the after-tax cost of debt is used to reflect this tax shield. Specifically, the formula for the after-tax cost of debt is the nominal interest rate on the debt multiplied by (1 - tax rate). As a result, a higher tax rate leads to greater tax savings on interest payments, effectively decreasing the after-tax cost of debt. Thus, the overall cost of debt in WACC decreases as the tax rate increases since the company benefits from lower taxes payable due to the interest deductions.

In summary, the interaction between the tax rate and the cost of debt leads to a decrease in the effective cost of borrowing, which is correctly highlighted in the first choice. This acknowledges the advantage that firms gain through tax savings, enhancing the efficiency of their capital structure decisions related to debt financing.