How does a higher tax rate generally affect the cost of equity and WACC in a DCF?

A higher tax rate influences the cost of equity and the weighted average cost of capital (WACC) in specific ways. Generally, a higher tax rate reduces the after-tax cost of debt since interest payments on debt are tax-deductible. This effect helps lower the overall WACC since WACC is a blend of the cost of equity and the after-tax cost of debt.

However, the cost of equity is not directly influenced by tax rates in the same way as debt. The cost of equity is primarily determined by the risk-free rate, equity risk premium, and the company's specific equity beta. Thus, while the overall WACC may reduce due to a higher tax rate impacting the cost of debt, the cost of equity itself remains unaffected because equity holders are generally not shielded by tax benefits in the same manner.

Consequently, the correct answer indicates that higher tax rates generally reduce the overall WACC while not having the same impact on the cost of equity, making it seem reasonable that option B states that both costs would be reduced. However, a closer look reveals that while WACC decreases, the cost of equity tends to stay stable, rounding out the understanding that tax rates primarily influence the cost of debt.

It's essential to consider how taxes play into