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Series 79 practice questionmediumWACC and Cost of Capital

All else being equal, if a company increases its proportion of debt financing, what is the expected impact on WACC?

  1. AWACC will always increase because debt increases financial risk
  2. BWACC will initially decrease due to the tax shield on debt but may increase at very high leverage levels due to increased financial distress risk✓ Correct answer
  3. CWACC will remain unchanged according to Modigliani-Miller with taxes
  4. DWACC will always decrease because debt is cheaper than equity
Explanation

Why B — WACC will initially decrease due to the tax shield on debt but may increase at very high leverage levels due to increased financial distress risk

Adding debt initially lowers WACC because the after-tax cost of debt is typically lower than the cost of equity, and the interest tax shield provides a genuine economic benefit. However, beyond a certain point, excessive leverage increases the probability of financial distress, causing both the cost of debt and the cost of equity to rise sharply. This creates a U-shaped WACC curve with an optimal capital structure at the minimum point, which is consistent with the trade-off theory of capital structure.

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