Question

Which of the following statements does correctly explain the effect of additional debt on the weighted average cost of capital (WACC)? Debtholders’ prior and "fixed" claim decreases the risk of stockholders’ "residual" claim, so the cost of stock (rs) goes down. Additional debt decreases the pre-tax of cost of debt (rd) because the decresaed risk of bankruptcy. The net effect of additional debt on WACC is to increase WACC. The net effect of additional debt on WACC is uncertain.

Answer 1

Answer: The net effect of additional debt on WACC is uncertain.

Explanation:

Weighted Average Cost of Capital (WACC) refers to the rate of return that a company is paying it's capital providers on average be it debt holders or shareholders.

Adding additional debt to the mix effects the WACC in an uncertain way due to the different ways the WACC could react. For example, adding additional debt decreases the after-tax cost of debt because debt is tax deductible which means that more money can flow to shareholders so that reduces the cost of equity. At the same time however, Additional debt can increase the risk of bankruptcy meaning that the before tax cost of debt rises which also increase the WACC.

The effect can swing either way thereby making it uncertain.