Capital Structure and Leverage: The WACC Lab

The Weighted Average Cost of Capital (WACC)

A company doesn’t finance itself from a single source — usually a mix of debt and equity. WACC is the weighted average of the cost of both sources, weighted by each source’s share of total capital:

WACC = (Debt Weight × After-Tax Cost of Debt) + (Equity Weight × Cost of Equity)

This WACC is the discount rate used to value projects and companies (as you’ll see with NPV and DCF later) — because it reflects the true cost of every pound the company uses to finance itself.

Optimal Capital Structure

Plot WACC on the vertical axis against the debt-to-total-capital ratio on the horizontal axis, and the curve typically forms a U shape: WACC first falls as cheap debt increases (since debt is cheaper than equity), but past a certain point, more debt raises bankruptcy risk, pushing up both the cost of debt and the cost of equity, and WACC rises again. The optimal capital structure is the point where WACC sits at its lowest possible level.

Financial leverage: a double-edged sword

When a company uses debt instead of equity to finance itself, it creates a magnifying effect on shareholder returns:

• If operating return on capital (ROIC) is higher than the after-tax cost of debt → debt increases return on equity (ROE) for shareholders. This is called positive leverage.
• If operating return is lower than the cost of debt → debt reduces ROE and increases risk. Negative leverage.

In other words: debt magnifies whatever the outcome is — good or bad.

Try it yourself

Change the debt weight in the capital structure, the cost of debt, and beta, and watch WACC and ROE respond together.

Once a company has reached the lowest cost of capital it can, the natural next question is: what does it do with the profits it earns? Keep them, or pay them out? The next lesson answers exactly that.