As the debt ratio rises, the WACC is reduced because the after-tax cost of debt is usually lower than the cost of equity.What limits the substitution of debt for equity in the capital structure is that as the debt ratio rises the costs of both components eventually increase.

Question

Quizplus · Accepted Answer

The Weighted Average Cost of Capital (WACC) initially decreases with more debt due to the tax shield on interest. However, excessive debt increases financial risk, raising both the cost of debt and equity, which eventually increases WACC.

As the Debt Ratio Rises, the WACC Is Reduced Because