Answer (A) is correct . An increase in the corporate income tax rate might encourage a company to borrow because interest on debt is tax deductible, whereas dividends are not. Accordingly, an increase in the tax rate means that the after-tax cost of debt capital will decrease. Given equal interest rates, a firm with a high tax rate will have a lower after-tax cost of debt capital than a firm with a low tax rate.
Answer (B) is incorrect because Increased uncertainty encourages equity financing. Dividends do not have to be paid in bad years, but interest on debt is a fixed charge.
Answer (C) is incorrect because An increase in interest rates discourages debt financing.
Answer (D) is incorrect because An increase in the price-earnings ratio means that the return to shareholders (equity investors) is declining; therefore, equity capital is a more attractive financing alternative.
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