Question

What impact does the use of debt to finance in business have on the company's WACC and why?

Answer 1

Cost of debt means the rate of return wihich a company is providing to its creditors and debt security owners. Normally debt holders are paid periodical fixed payments in return for their debt invest in the company. For example Normally Bonds are treated to be a safer investment as compared to shares , since it involves periodical fixed payments. Weighted Average Cost of Capital (WACC ) is a combined ratio, which is a pool of both debt and equity finance. WACC is calculated using the following formula :-

= (cost of equity * weight of equity) + (cost of debt * weight of debt)

Normally cost of debt is more cheaper as compared to cost of equity. Only after accepting all the borrowing that can be taken, then only an entrepreneur will accept funds in the form of stock, which is more costly than debt financing. So when there is an increase in debt component in the  WACC, overall WACC will be decreased due to the effect of debt component .

For enjoying the lower WACC due the existance of debt component we have to check whether the cost of debt is more cheaper as compared to the cost of equity . Normally, increase in debt component will reduce the W.A.C.C., but there are exceptional cases also.