Question

Debt is typically lower cost than equity. However, what are some advantages to increasing WACC and having a capital structure weighted with more equity? (Please explain this in some detail to help me understand)

Answer 1

Debt has lower cost than equity:-

Yes Debt has normally lower cost than equity because interest payment on Debt treated as expense in organization which save tax outflow whereas return on equity is a transaction which occurs after payment of tax expense.

Example:-

Debt interest Rate 10%

Return of Capital 10%
Tax Rate 30%

In this case company’s effective cost of debt is = (10-3=7%)

Due to no benefit of tax cost of equity would be 10%.

Advantages of increasing Weighted Average Cost of Capital (WACC)

There is some differences between debt and equity that is

1. Debt is required to pay after certain period and nonpayment attract various penalties and other obligations. No such requirement exists in case of equity hence some financial expert feels that it is advantageous to increase WACC.
2. No immediate cash flow required out of the business.
3. Long Term planning
4. No Credit risk attract
5. No credit rating required
6. This type of funding will carry expertise, skill, growth ideas and better management.
7. Investors ready to provide follow up funding also.
8. Lower Break even cost in case of equity financing.
9. No security is required for this kind of financing
10. No restriction in business like debt financing.