Final answer:
Income taxes decrease the cost of debt for firms because interest on debt is tax-deductible. However, this does not necessarily decrease the overall cost of capital, as rising interest rates can result from government borrowing crowding out business investment.
Step-by-step explanation:
The question posed by the student regards the effect of income taxes on the cost of debt and the cost of capital for a firm. Specifically, income taxes have the effect of decreasing the cost of debt because the interest payments on debt are tax-deductible, meaning the post-tax cost is lower than the pre-tax cost. This deduction reduces the effective interest rate paid by the corporation. As a result, option B) decreasing the cost of debt is the correct answer.
However, income taxes do not necessarily decrease the cost of capital because while they may decrease the cost of debt, they do not impact the cost of equity in the same manner. Rather, the presence of taxes can lead to what is known as the 'crowding out' effect, where government spending and borrowing cause interest rates to rise, potentially making it more expensive for businesses to borrow and invest.