Work the WACC Leverage Trade-Off
Calculate WACC across leverage cases and explain why the cheapest debt case may not be optimal.
A company with $200 million enterprise value is considering three target capital structures: 0% debt, 30% debt, and 60% debt. Tax rate is 25%. Base unlevered cost of capital is near 10.2%. Debt gets more expensive as leverage rises, and equity holders demand more return as their claim becomes riskier. WACC = E/(D+E) x cost of equity + D/(D+E) x after-tax cost of debt, with costs updated for leverage risk. The common shortcut is to use today's cost of debt and today's cost of equity at every leverage level. That makes leverage look artificially cheap because it ignores risk repricing.…
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