Interest on debts is a tax deductible expense, how increase in tax rate will affect debts :

Debt will become relatively cheaper than equity

The correct answer is option (1)- Debt will become relatively cheaper than equity.

Debt and equity differ significantly in their cost and riskiness for the firm. The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore, is likely to lower the over-all cost of capital of the firm provided that the cost of equity remains unaffected. 

When the tax rate increases, the tax deductibility of interest on debt becomes more beneficial. This effectively reduces the cost of debt, making it relatively cheaper compared to equity. Since the interest paid on debt is tax-deductible, higher tax rates reduce the effective cost of borrowing, giving debt a tax advantage over equity. Therefore, companies may prefer debt financing over equity when tax rates are higher.