Two companies are exactly the same, but one has debt and one does not — which will have the higher WACC (up to a point)?

Two companies are exactly the same, but one has debt and one does not — which will have the higher WACC (up to a point)?

• A. The company with debt
• B. The company without debt
• C. The company without debt will have higher WACC up to a point
• D. WACC will be the same

Answer: (C)

Leveraging adds a tax shield that makes debt cheaper on an after-tax basis, so as you replace equity with debt the overall cost of capital can fall. The after-tax cost of debt is Rd multiplied by (1 minus Tc), which is typically lower than the cost of equity, and the weighted mix shifts toward debt. This lowers the WACC in the early to moderate leverage range, even though equity requires a higher return to reflect the greater risk. Because the two firms are otherwise identical, the firm with debt will have a lower WACC than the all-equity firm up to the point where the additional financial risk from debt raises the cost of equity enough or debt costs rise due to distress. Therefore, the all-equity company will have the higher WACC in that range. Only at extreme leverage would the WACC start rising again, potentially narrowing the difference.

Leveraging adds a tax shield that makes debt cheaper on an after-tax basis, so as you replace equity with debt the overall cost of capital can fall. The after-tax cost of debt is Rd multiplied by (1 minus Tc), which is typically lower than the cost of equity, and the weighted mix shifts toward debt. This lowers the WACC in the early to moderate leverage range, even though equity requires a higher return to reflect the greater risk. Because the two firms are otherwise identical, the firm with debt will have a lower WACC than the all-equity firm up to the point where the additional financial risk from debt raises the cost of equity enough or debt costs rise due to distress. Therefore, the all-equity company will have the higher WACC in that range. Only at extreme leverage would the WACC start rising again, potentially narrowing the difference.