Why is debt often cheaper than equity in the WACC calculation?

Why is debt often cheaper than equity in the WACC calculation?

• A. Because debt yields higher returns
• B. Because interest is tax-deductible, debt is senior, and rates are lower
• C. Because debt has no risk
• D. Because debt does not affect beta

Answer: (B)

Debt tends to be cheaper in WACC because three factors reduce its after‑tax cost and risk premium. First, interest on debt is tax‑deductible, creating a tax shield. In the WACC formula, the cost of debt is used as Rd multiplied by (1 − Tc), so the after‑tax cost drops by the tax rate. This makes debt cheaper than equity from a cash‑flow perspective. Second, debt is senior in the capital structure. If a company faces trouble, debt holders are paid before equity holders, so lenders face less risk. That lower risk translates into lower required returns by creditors. Third, interest rates on debt are typically lower than the returns demanded by equity investors. Debt investors receive fixed payments and have priority in distress, which lowers their required compensation relative to shareholders who bear residual risk and have upside potential. Because of these factors, the after‑tax cost of debt is usually smaller than the cost of equity, pulling the WACC down when more debt is used (subject to not overburdening the company with financial distress).

Debt tends to be cheaper in WACC because three factors reduce its after‑tax cost and risk premium.

First, interest on debt is tax‑deductible, creating a tax shield. In the WACC formula, the cost of debt is used as Rd multiplied by (1 − Tc), so the after‑tax cost drops by the tax rate. This makes debt cheaper than equity from a cash‑flow perspective.

Second, debt is senior in the capital structure. If a company faces trouble, debt holders are paid before equity holders, so lenders face less risk. That lower risk translates into lower required returns by creditors.

Third, interest rates on debt are typically lower than the returns demanded by equity investors. Debt investors receive fixed payments and have priority in distress, which lowers their required compensation relative to shareholders who bear residual risk and have upside potential.

Because of these factors, the after‑tax cost of debt is usually smaller than the cost of equity, pulling the WACC down when more debt is used (subject to not overburdening the company with financial distress).