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.