ACCA Financial Management (F9) Certification Practice Exam

What occurs to the Weighted Average Cost of Capital (WACC) when gearing increases initially according to traditional theory?

1. WACC will increase indefinitely

2. WACC will remain constant

3. WACC will decline initially

4. WACC will decline linearly

The correct answer is: WACC will decline initially

The correct response indicates that as gearing—meaning the ratio of debt to equity—increases, the Weighted Average Cost of Capital (WACC) initially declines. This phenomenon is explained by traditional capital structure theory. When a company increases its gearing by taking on more debt, the cost of equity typically rises because equity holders require a higher return for the increased financial risk. However, the cost of debt is often lower than the cost of equity because interest on debt is tax-deductible, which enhances the company's value through the tax shield effect. As a result, in the early stages of increased gearing, the cheaper cost of debt offsets the rising cost of equity. Initially, this leads to a reduction in WACC because the overall capital structure has a larger proportion of debt, which carries a lower cost relative to equity. The overall average cost of capital decreases as the benefits of using cheaper debt financing dominate the equation. As gearing continues to rise beyond a certain point, WACC could potentially increase due to escalating risks associated with excessive leverage, but that is outside the scope of what happens in the initial phase of increased gearing. Therefore, the assertion that WACC declines initially aligns correctly with traditional theory.