Answer: decreases

## Explanation When interest expense becomes tax deductible for a company with taxable income, the effective marginal cost of debt decreases. This is because: 1. **Tax Shield Effect**: Interest expense reduces taxable income, which in turn reduces the company's tax liability. 2. **After-tax Cost of Debt**: The effective cost of debt is calculated as: **After-tax cost of debt = Pre-tax cost of debt × (1 - Tax rate)** 3. **Mathematical Explanation**: - Without tax deductibility: Effective cost = Pre-tax cost - With tax deductibility: Effective cost = Pre-tax cost × (1 - Tax rate) Since (1 - Tax rate) is less than 1 (assuming positive tax rate), the after-tax cost is lower than the pre-tax cost. 4. **Example**: - Pre-tax interest rate: 8% - Tax rate: 30% - Without tax deductibility: Effective cost = 8% - With tax deductibility: Effective cost = 8% × (1 - 0.30) = 8% × 0.70 = 5.6% Therefore, when interest becomes tax deductible, the effective marginal cost of debt decreases, making debt financing more attractive for companies with taxable income.

Author: LeetQuiz .