Area I: Business Analysis — CPA Practice Question 13

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Recall the U-shaped WACC curve relative to leverage. Debt provides a tax shield (lowering WACC), but high leverage increases financial distress costs (raising WACC).

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B.WACC may initially decrease, but will eventually increase if the leverage becomes excessive.✓ Correct

B

Adding debt initially lowers WACC because the after-tax cost of debt is lower than the cost of equity. However, as leverage increases, the risk of bankruptcy increases, causing lenders to demand higher rates and equity holders to demand a higher premium, eventually causing WACC to rise.

Common mistakes

Assuming debt always lowers WACC; ignoring the risk premium increase.

A company with a current WACC of 10% is considering issuing bonds to buy back stock, increasing its debt-to-equity ratio. The new debt will have a higher interest rate than existing debt due to increased risk. Which of the following statements BEST describes the likely impact on the company's WACC?

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