Why does debt contribute less to WACC than equity?

Why does debt contribute less to WACC than equity?

• A. Debt has lower interest rates than equity costs
• B. Debt is more expensive than equity
• C. Debt ownership is riskier
• D. Debt has no tax advantages

Answer: (A)

Debt contributes less to the Weighted Average Cost of Capital (WACC) than equity primarily because it typically carries lower interest rates compared to the cost of equity. Lenders require a lower return on their loans due to the priority of debt in the capital structure; in the event of liquidation, debt holders are paid before equity holders. This results in a lower cost associated with servicing debts, as interest payments are often fixed and can be lower than the expected returns demanded by equity investors who take on more risk. Additionally, interest on debt is usually tax-deductible, further reducing the effective cost of debt beyond just the interest rate itself. Overall, the lower cost of debt, coupled with its preferential treatment in capital structure, means that debt financing typically contributes less to WACC than equity financing, which comes with higher return expectations reflecting its higher risk profile to investors.

Debt contributes less to the Weighted Average Cost of Capital (WACC) than equity primarily because it typically carries lower interest rates compared to the cost of equity. Lenders require a lower return on their loans due to the priority of debt in the capital structure; in the event of liquidation, debt holders are paid before equity holders. This results in a lower cost associated with servicing debts, as interest payments are often fixed and can be lower than the expected returns demanded by equity investors who take on more risk. Additionally, interest on debt is usually tax-deductible, further reducing the effective cost of debt beyond just the interest rate itself.

Overall, the lower cost of debt, coupled with its preferential treatment in capital structure, means that debt financing typically contributes less to WACC than equity financing, which comes with higher return expectations reflecting its higher risk profile to investors.