How does WACC behave when the cost of debt is lower than the cost of equity?

When the cost of debt is lower than the cost of equity, the Weighted Average Cost of Capital (WACC) is typically lower. WACC represents the average rate that a company is expected to pay its security holders to finance its assets, and it takes into account the relative weights of each component of the capital structure, namely equity and debt.

In scenarios where the cost of debt is less than the cost of equity, utilizing more debt financing can reduce the overall WACC. This is primarily due to the tax deductibility of interest payments, which effectively lowers the cost of borrowing. As the proportion of debt in the capital structure increases (up to a certain optimal point), the lower cost of debt pulls down the average cost of capital. Hence, when companies make financing decisions, they often find that an appropriate mix of debt can lead to a more favorable cost of capital.

While increasing equity financing usually incurs a higher cost due to the expected returns by equity investors, utilizing cheaper debt allows the firm to achieve a lower overall WACC. Therefore, the behavior of WACC in such a situation supports the notion that it would be lower, reflecting the benefits of using less expensive debt financing in the capital structure.