Series 79 practice questionmediumWACC Sensitivity
A company increases its debt-to-total capitalization ratio from 30% to 50%. Assuming the after-tax cost of debt is less than the cost of equity, how will this affect the WACC, all else equal?
- AThe WACC will immediately increase due to higher risk.
- BThe WACC will increase without limit.
- CThe WACC will remain unchanged.
- DThe WACC will decrease, up to a certain level of leverage.✓ Correct answer
Explanation
Why D — The WACC will decrease, up to a certain level of leverage.
Increasing debt lowers WACC up to a point because of the tax shield and lower cost compared to equity. After a certain point, higher financial risk causes WACC to rise, but initially, it decreases.
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