In the presence of corporate taxes, does increasing debt typically reduce the WACC?

• A. WACC stays the same
• B. Yes, due to the tax shield from debt
• C. WACC increases
• D. WACC becomes zero

Answer: (B)

The tax deductibility of interest creates a tax shield that lowers the after‑tax cost of debt. Since WACC is the weighted average of the costs of debt and equity, weighted by their proportions in the capital mix, boosting the debt share brings in more of the cheaper after‑tax debt relative to equity. As long as the after‑tax cost of debt (Rd(1−Tc)) remains lower than the cost of equity, the overall WACC falls with more leverage. This is the essence of why debt can reduce WACC in a taxed environment. In practice, very high leverage can raise other costs (financial distress, agency costs) that limit how far WACC can fall, but the typical effect is a reduction due to the debt tax shield.