Question

Debt is nearly always a less costly source of financing than equity. Does it follow then that most firms could decrease their WACC if they simply used more debt and less equity in their capital structure?

Answer 1

The Debt is Less costly than equity and also the Interest payment is tax deductible which helps the company to lower the weighted average cost of capital, the firm can add more debt to the portfolio for reducing the cost of capital but it has many consequences like,

1. The firm has to make regular interest payment to the shareholder whether the firm has enough liquidity or not while it is not obliged for the equityholers.

2. If the firm add more debt in the portfolio then the cost of debt would rise significantly as the investor would expect more return from the company as it would be more riskier because the interest payment affect the operating performance of the company.