How does the level of debt affect the weighted average cost of capital (WACC)?Multiple choice question.The WACC initially rises and then falls as debt increases.The WACC initially falls and then rises as debt increases.The WACC always increases as debt increases.The WACC always falls as debt increases.

The WACC initially falls and then rises as debt increases.

Here's why:

1. The Weighted Average Cost of Capital (WACC) is the average rate of return a company is expected to pay its investors; the weights are the proportion of each financing component in the company's capital structure.

2. When a company increases its debt, the cost of debt is initially less than the cost of equity. This is because interest expenses from debt are tax-deductible, which can provide a company with tax shield benefits. As a result, the WACC decreases.

3. However, as the level of debt continues to increase, the financial risk of the company also increases. This is because the company has to meet its debt obligations, i.e., interest payments and principal repayment, regardless of its cash flow situation.

4. The increased financial risk leads to a higher required return on equity, as equity holders require compensation for the increased risk. This, in turn, increases the cost of equity.

5. At a certain point, the increased cost of equity will outweigh the benefits of the tax shield from debt, causing the WACC to start increasing.

6. Therefore, the relationship between the level of debt and WACC is such that WACC initially falls with an increase in debt, but after a certain point, it starts to rise. This relationship is often described as a U-shaped curve.