Explanation

When interest deductibility is allowed, interest expenses are tax-deductible. This creates a tax shield that reduces the effective cost of debt. The formula for the after-tax cost of debt is:

After-tax cost of debt = Before-tax cost of debt × (1 - Tax Rate)

When the tax rate increases:

1. The tax shield from interest deductibility becomes larger
2. The after-tax cost of debt decreases
3. Since debt is typically a component of a company's weighted average cost of capital (WACC), a lower after-tax cost of debt reduces the overall WACC

Therefore, an increase in the tax rate (when interest is deductible) will cause a company's cost of capital to decrease.

Key Concept: The tax shield from interest deductibility reduces the effective cost of debt, and this benefit increases with higher tax rates.