What is the effect of interest being tax-deductible on WACC?

• A. It lowers the overall WACC
• B. It raises the overall WACC
• C. It has no effect on WACC
• D. It creates volatility in WACC

Answer: (A)

The effect of interest being tax-deductible on the Weighted Average Cost of Capital (WACC) is that it lowers the overall WACC. This occurs because the cost of debt is effectively reduced by the tax shield that comes from the deductibility of interest expenses.

When a company incurs debt, the interest it pays on that debt can be deducted from its taxable income, thus lowering its overall tax burden. This tax shield means that the company pays less in taxes, which effectively reduces the cost associated with using debt.

Since WACC is calculated as the weighted average of the cost of equity and the after-tax cost of debt, the inclusion of the tax shield decreases the after-tax cost of debt. Consequently, when the after-tax cost of debt decreases while the cost of equity remains constant, the overall WACC is lowered.

In summary, the tax deductibility of interest expenses enhances the attractiveness of debt financing compared to equity financing, leading to a reduction in the overall WACC as the structure of capital becomes more efficient.