According to the traditional theory of gearing, how does WACC change as KE rises initially?

The correct answer is that WACC decreases initially and then increases, according to the traditional theory of gearing. This theory posits that as a company increases its use of debt financing in its capital structure (leveraging), the overall cost of capital, represented by the Weighted Average Cost of Capital (WACC), will decline up to a certain point.

Initially, the increase in leverage (increasing the proportion of debt relative to equity) leads to a lower overall cost of capital. This is because debt is generally a cheaper form of financing compared to equity; interest payments on debt are tax-deductible, which provides a tax shield. As a firm takes on more debt, the cost of equity (KE) may increase due to the increased financial risk perceived by equity investors, but the cheaper debt can initially outweigh this effect, resulting in a declining WACC.

However, after reaching an optimal level of debt, additional borrowing leads to higher financial risk for the firm. This increased risk raises the cost of equity more significantly as investors demand higher returns to compensate for the increased risk of default. Eventually, this increased cost of equity causes WACC to rise as leverage continues to increase beyond the optimal level.

Thus, the WACC will initially decrease during the early stages