Why might a company without debt generally have a higher WACC?

• A. Because it has no fixed obligations
• B. Because debt is considered cheaper than equity
• C. Because debt raises the risk of bankruptcy
• D. Because it lacks financial flexibility

Answer: (B)

A company without debt may generally have a higher Weighted Average Cost of Capital (WACC) because debt is considered cheaper than equity. When companies use debt financing, they benefit from the tax shield provided by interest payments, which makes debt a lower-cost source of capital compared to equity financing.

Since interest on debt is tax-deductible, the overall cost of capital is reduced when a company utilizes debt. Equity holders typically require a higher return compared to debt holders due to the higher risks associated with equity investment. As a result, if a company is entirely equity-financed (without any debt), it must bear the higher cost of equity without the advantages that come with leveraging debt. This can lead to a higher WACC since the overall cost of capital is a weighted combination of both equity and debt, and without debt, the entire capital structure is weighted toward the more expensive equity.

In cases where a company may not have financial flexibility, or the risk profile is such that it does not utilize debt, the reliance on equity financing can lead to an elevated WACC compared to companies that incorporate debt effectively into their capital structure.