How is the effective cost of debt calculated in WACC?

The effective cost of debt is calculated by taking the nominal cost of debt and adjusting it for the tax benefits associated with interest payments. When a company borrows money, the interest it pays on that debt is tax-deductible, which effectively reduces the net cost of borrowing. This is why the calculation involves multiplying the cost of debt by (1 - tax rate).

This adjustment reflects the fact that the actual economic cost to the company of its debt financing is lower than the stated cost because it can deduct interest expense on its tax return. Effectively, this provides a more accurate picture of how much the debt actually costs the company in terms of cash flow after accounting for tax savings.

The other choices do not accurately reflect the calculation of the effective cost of debt in WACC. Simply adding the cost of debt to total equity does not consider the tax effects, while dividing the cost of debt by total assets or adjusting it for inflation does not pertain to the calculation of WACC.