IBD interview question: How does increasing leverage affect wacc?
How does increasing leverage affect wacc? I know that up to some point that taking on more debt actually decreases wacc, but beyond that point, additional debt will increase wacc, but why is it a U shaped curve? I guess the fundamental question I want to ask is that how does increasing leverage affect cost of debt, cost of equity, and wacc?
Cost of debt: it goes up because as you increase leverage, you increase risk
Cost of equity: it goes up because as you increase leverage, you increase risk
WACC: it should go down because as the percentage of your capital structure that is debt increases, the percentage of your capital structure that is stock decreases. Since the cost of stock is greater than the cost of debt, even if both costs increase, you lowering the percentage of stock will lower the highest cost of capital, therefore lowering the WACC
As a friendly suggestion, I would highly suggest getting an interview guide. I know for a fact that both the BIWS and WSO guides cover this question.
It's because after a certain point if creditors/lenders perceive a company's capital structure to be getting too leveraged, then they will begin to ask for higher interest rates on the debt that they are willing to provide. For sake of example, if a company that currently had A rated debt, they could raise debt at say 4%...if they keep raising debt at 4% eventually it won't be an A rated company anymore because the capital structure will be too risky, so it will become a B rated company, and that debt will have to be raised at 5% and so on and so forth.
Since you are taking a weighted average of both the debt and equity in the capital structure, at some point even though your cost of debt is lower than your cost of equity, you will have so much debt in the capital structure, like for sake of example 80%...that will be the driving force behind your WACC...thus it will lower it to a point, but when the scale begins to tip, and there gets to be too much debt, your cost of debt will rise, and when it happens enough...your WACC will as well.
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