Explanation

When interest expense is not tax deductible, the tax shield benefit of debt financing is eliminated. The Weighted Average Cost of Capital (WACC) formula is:

$WACC = \frac{E}{V} \times r_e + \frac{D}{V} \times r_d \times (1 - T)$

Where:

• $E/V$ = proportion of equity in capital structure
• $r_e$ = cost of equity
• $D/V$ = proportion of debt in capital structure
• $r_d$ = cost of debt
• $T$ = marginal tax rate

Key insight: When interest expense is not tax deductible, the term $(1 - T)$ becomes irrelevant because there is no tax shield. The after-tax cost of debt is simply $r_d$ (not $r_d \times (1 - T)$).

Therefore, the WACC formula simplifies to:

$WACC = \frac{E}{V} \times r_e + \frac{D}{V} \times r_d$

Since the tax rate $T$ does not appear in this simplified formula, changes in the marginal tax rate have no effect on WACC when interest expense is not tax deductible.

Why other options are incorrect:

• A (decreases): This would be true if interest expense were tax deductible, as higher tax rates increase the tax shield benefit, reducing the after-tax cost of debt.
• C (increases): There's no mechanism for WACC to increase with tax rates when interest is not deductible, as the tax rate doesn't affect the calculation.

Conclusion: With no tax deductibility of interest, WACC remains unchanged regardless of changes in the marginal tax rate.