If interest expense lowers taxes, why does the WACC not decrease indefinitely with the addition of more debt?
A) The tax shield effect of debt will result in a lower cost of equity.
B) Increasing debt too much can result in a greater likelihood of firm failure (financial distress).
C) A firm's common stock price will not be affected by the amount of debt a firm uses.
D) Too much common equity increases the probability of bankruptcy.

Question

Quizplus · Accepted Answer

While interest expense lowers taxes, adding too much debt can increase the likelihood of financial distress or firm failure, which can increase the cost of debt and/or cause the cost of equity to increase. This can ultimately increase the overall WACC and prevent it from decreasing indefinitely with more debt. Therefore, there is an optimal level of debt for each firm that minimizes the WACC.

If Interest Expense Lowers Taxes, Why Does the WACC Not