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You are a junior financial analyst at a small firm and another junior analyst (Gonzaga graduate)...

You are a junior financial analyst at a small firm and another junior analyst (Gonzaga graduate) 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. How would you respond?

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Answer #1

It is true that increasing debt decreases the WACC. But, this is only to a certain extent. If the firm is over-leveraged, then the benefits of debt may not be significant. The firm will have to meet its debt obligations regardless of the state of the economy. In good times it is easy to pay interests while in bad times it is extremely difficult to pay interests. In such a situation, the firm may be forced to bankruptcy. The cost of bankruptcy may outweigh any benefits that increased debt would provide, thus destroying the value of the frim.

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