In a scenario where one company has debt and another does not, which is likely to have a higher WACC?

• A. The company with debt
• B. The company without debt
• C. Both will have equal WACC
• D. It cannot be determined without additional data

Answer: (B)

The company without debt is likely to have a higher Weighted Average Cost of Capital (WACC) for a number of reasons related to capital structure and the costs associated with equity and debt financing.

When a company incorporates debt into its capital structure, it can benefit from the tax shield that debt provides, as interest payments are tax-deductible. This effectively lowers the overall cost of capital for the company because it reduces their taxable income, leading to lower taxes and hence a higher net income. Furthermore, debt is generally cheaper than equity. Companies that take on debt can leverage this cheaper capital to improve their returns on equity, often resulting in a lower WACC.

In contrast, a company without debt relies solely on equity for its financing needs, which typically comes at a higher cost due to the expected returns required by equity investors. Equity is generally more expensive than debt because equity investors take on more risk; they are not guaranteed returns in the same way that debt holders are.

Consequently, when analyzing these capital structures, the company without debt faces a higher WACC due to the higher cost of equity and the absence of the lower-cost debt option. Therefore, the conclusion that the company without debt has a higher WACC is grounded in the principles of corporate finance