Question

You are a junior financial analyst at a small firm and another junior analyst suggests that the firm should leverage up (increase their D/A ratio) because the cost of debt is less than the cost of equity and, therefore, leveraging up will cause the firm’s WACC to decrease and the firm’s value to increase. If you were asked for your opinion, how would you respond?

Answer 1

No this is incorrect. Debt has benefits in the form on tax shields because interest payments are tax deductible and debt is cheaper so effective cost of debt is less than cost of equity. Hence, initially increasing debt means lesser WACC. As higher debt means more risk, there is higher chance of bankruptcy so after a point, the benefits of debt are outweighed by the cost of financial distress. And then cost of debt rises and WACC starts rising. Firm's value is indirectly related to WACC-so when WACC increases firm's value decrease.