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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

According to the traditional view of capital structure, how does a company's weighted average cost of capital (WACC) behave as gearing rises from zero?

Under the traditional view, WACC first falls as cheaper debt is introduced, reaches a minimum at the optimal gearing level, and then rises as financial risk pushes up the costs of both equity and debt, giving a U-shaped curve.

  1. AWACC rises continuously because equity holders demand ever higher returns
  2. BWACC first falls, reaches a minimum at an optimal gearing level, and then risesCorrect
  3. CWACC stays constant at all gearing levels because risk and return offset exactly
  4. DWACC falls continuously because debt is always cheaper than equity
  5. WACC rises at first and then falls once the company becomes highly geared

Explanation

The traditional view says that moderate gearing replaces dearer equity with cheaper debt, lowering WACC. At high gearing, financial risk raises both the cost of equity and the cost of debt, so WACC rises again. This gives a U-shaped curve with an optimal point. Constant WACC is the Modigliani-Miller no-tax result, not the traditional view.

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