What shape describes how increasing debt affects WACC as debt increases?

What shape describes how increasing debt affects WACC as debt increases?

• A. Linear increase
• B. U-shaped: decreases WACC to a point, then increases
• C. Flat line
• D. Decreases monotonically

Answer: (B)

Adding debt changes the mix of funding and introduces a trade-off. Initially, taking on more debt lowers the overall cost of capital because debt is cheaper than equity and the interest is tax-deductible, so the after-tax cost of debt helps reduce WACC. But as leverage grows, the company takes on more financial risk, which pushes up both the cost of debt and the cost of equity. The rising costs eventually outweigh the tax shield benefit, causing WACC to start climbing again. This combination—the initial fall followed by a rise—produces a U-shaped relationship, where WACC decreases to a point and then increases as debt increases.

Adding debt changes the mix of funding and introduces a trade-off. Initially, taking on more debt lowers the overall cost of capital because debt is cheaper than equity and the interest is tax-deductible, so the after-tax cost of debt helps reduce WACC. But as leverage grows, the company takes on more financial risk, which pushes up both the cost of debt and the cost of equity. The rising costs eventually outweigh the tax shield benefit, causing WACC to start climbing again. This combination—the initial fall followed by a rise—produces a U-shaped relationship, where WACC decreases to a point and then increases as debt increases.