Question

The firm's weighted-average cost of capital is likely to _________________ if debt financing is used to excess.

Select one:

A. increase

B. decrease

C. remain unchanged

D. collapse

Answer 1

Answer is b, the WACC will decrease

Weighted average cost of capital as its name says is the mix of equity and debt in certain ratios. In order to answer the questions lets take an example  

WACC = We Ke + Wd Kd ( 1 - T)

Where We = Weight of equity = 0.5

Ke = Cost of equity = 10%

Wd  = weight of debt = 0.5

Kd   = Cost of debt = 12%

T = Tax rate = 30%

Therefore WACC = 0.5 * 10 + 0.5 * 12 *(1 - .30)

= 9.2%

Now lets change the scenario and increase the weight of debt to 0.7 and then equity would become 0.3. remaining data is same

Again

WACC = 0.3 * 10 + 0.7 * 12 * (1 - .30)

= 3 + 5.88

= 8.88%

Conclusion = So we can see that WACC of the company Decresed as we increased the debt financing it is because the interest on debt is tax deductible. therefore if we increase the debt the interest part also gets increses and we get tax rebate on the same and as a result WACC reduces.

Althogh financing only through debt can be riskey because if the company will not be able to generate revenue still it has to pay interest on the borrowing