If two companies have identical capital structures, which company would have the higher WACC based on size alone?

If two companies have identical capital structures, which company would have the higher WACC based on size alone?

• A. The $5 billion market cap company
• B. The WACC would be the same for both
• C. The $500 million market cap company
• D. It depends on the tax rate

Answer: (C)

WACC reflects the return required by both debt and equity holders, weighted by their shares in the capital structure. If two firms have identical capital structures, the weights are the same and the after-tax cost of debt is driven by the same factors (assuming the tax rate is the same). The part that can vary with size is the cost of equity, which depends on risk. Smaller firms tend to be riskier—less diversified, with more volatile cash flows—so investors demand a higher return on equity (higher beta). That higher cost of equity raises the WACC, even though the debt terms and tax shield are unchanged. Therefore the smaller-cap company would have the higher WACC based on size alone. The tax rate or the idea that WACC would be the same aren’t the driving factors here, since the prompt specifies size as the only varying element.

WACC reflects the return required by both debt and equity holders, weighted by their shares in the capital structure. If two firms have identical capital structures, the weights are the same and the after-tax cost of debt is driven by the same factors (assuming the tax rate is the same). The part that can vary with size is the cost of equity, which depends on risk. Smaller firms tend to be riskier—less diversified, with more volatile cash flows—so investors demand a higher return on equity (higher beta). That higher cost of equity raises the WACC, even though the debt terms and tax shield are unchanged. Therefore the smaller-cap company would have the higher WACC based on size alone. The tax rate or the idea that WACC would be the same aren’t the driving factors here, since the prompt specifies size as the only varying element.