Why is the cost of debt multiplied by (1 − tax rate) in the WACC?
Show the answer and explanation
Answer: B. Because interest is tax deductible, so the firm's net cost is lower
The firm's tax bill falls when it pays interest, so the true cost of borrowing is less than the interest rate on the loan. Formula: After-tax cost of debt = Pre-tax cost of debt x (1 - Tax rate). Example: 6% x (1 - 0.25) = 4.5%. This is why WACC uses the after-tax figure. Dividends paid to shareholders are not deductible, so the cost of equity gets no such adjustment. Lenders being paid first explains why debt has a lower rate, not the tax adjustment.
Why the other options are wrong:
A. Because debt is less risky than equity, so its cost is lower - True, and it explains the lower pre-tax rate rather than the tax adjustment.
C. Because interest is a fixed contractual obligation - True, but that explains financial leverage rather than the (1 - tax rate) factor.