I understand what WACC is, how to calculate it, and the concept behind it. However, that being said, I still have a question:
WACC is a representation of the riskiness of an investment in a company (A company with higher WACC would have a higher risk), but at the same time if a company took on more debt, their WACC would lower. But wouldn't this make an investment in the company more risky, since the company has taken on more debt?
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As more debt is taken on, the company is perceived as riskier, so cost of equity actually increases. At some point, this cost of equity will increase faster than the "lowering effect" that debt has on the overall WACC. Overall, this makes WACC look like a U-shape. Technically speaking, every firm has an "ideal" equity-debt mix that would achieve the lowest cost of capital. If you want more detail on the topic: https://www.sapling.com/6700645/effect-debt-cost-equity
Very helpful. Thanks.
Good response. I would also note that there is a limit to the amount of debt a company can take on. As my debt position increases, the debt becomes more expensive.
This is caused by a few items, but assuming you've maxed your secured loans, each additional dollar of debt is less likely to be repaid and your cost of debt continues creeping upwards.
+SB
Also, WACC is a representation of the riskiness of the company's business, not their equity. Taking on more debt does not make the business riskier until you overload with debt and thus cannot operate normally.
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