ExpertHard1 markMultiple Choice
CPA · Question 13 · Area I: Business Analysis
A company with a current WACC of 10% is considering issuing bonds to buy back stock, increasing its debt-to-equity ratio. The new debt will have a higher interest rate than existing debt due to increased risk. Which of the following statements BEST describes the likely impact on the company's WACC?
A company with a current WACC of 10% is considering issuing bonds to buy back stock, increasing its debt-to-equity ratio. The new debt will have a higher interest rate than existing debt due to increased risk. Which of the following statements BEST describes the likely impact on the company's WACC?
Answer options:
A.
WACC will definitely decrease because debt is always cheaper than equity.
B.
WACC may initially decrease, but will eventually increase if the leverage becomes excessive.
C.
WACC will remain unchanged according to the static trade-off theory.
D.
WACC will increase immediately because the cost of equity will rise linearly to offset the cheaper debt.
How to approach this question
Recall the U-shaped WACC curve relative to leverage. Debt provides a tax shield (lowering WACC), but high leverage increases financial distress costs (raising WACC).
Full Answer
B.WACC may initially decrease, but will eventually increase if the leverage becomes excessive.✓ Correct
Adding debt initially lowers WACC because the after-tax cost of debt is lower than the cost of equity. However, as leverage increases, the risk of bankruptcy increases, causing lenders to demand higher rates and equity holders to demand a higher premium, eventually causing WACC to rise.
Common mistakes
Assuming debt always lowers WACC; ignoring the risk premium increase.
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