Which company will generally have a higher WACC, the one with debt or without debt?

Which company will generally have a higher WACC, the one with debt or without debt?

• A. The company with debt
• B. The company without debt
• C. Both will have the same WACC
• D. It depends on the tax rate

Answer: (B)

The company without debt will generally have a higher weighted average cost of capital (WACC) because it lacks the benefits that come from the use of debt. Debt can act as a cheaper source of financing due to the tax-deductibility of interest payments, which lowers the overall cost of capital for the company using debt. When a company takes on debt, it can leverage that borrowing to potentially achieve a higher return on equity, leading to a lower WACC overall. In contrast, a company that operates entirely on equity financing bears the full cost of equity, which is generally higher than the cost of debt. As a result, without the leverage effect provided by debt, the WACC for the company without debt will typically be higher. In addition to the tax deductibility, companies with no debt also face potential disadvantages in terms of capital structure flexibility and the potential for higher costs of equity due to perceived risk by investors. Thus, the absence of debt generally correlates with a higher WACC.

The company without debt will generally have a higher weighted average cost of capital (WACC) because it lacks the benefits that come from the use of debt. Debt can act as a cheaper source of financing due to the tax-deductibility of interest payments, which lowers the overall cost of capital for the company using debt.

When a company takes on debt, it can leverage that borrowing to potentially achieve a higher return on equity, leading to a lower WACC overall. In contrast, a company that operates entirely on equity financing bears the full cost of equity, which is generally higher than the cost of debt. As a result, without the leverage effect provided by debt, the WACC for the company without debt will typically be higher.

In addition to the tax deductibility, companies with no debt also face potential disadvantages in terms of capital structure flexibility and the potential for higher costs of equity due to perceived risk by investors. Thus, the absence of debt generally correlates with a higher WACC.