"How does WACC change if the company takes on more debt?" is a favorite associate-and-up interview question because the intuitive answer (more debt = more risk = higher WACC) is usually wrong, or at least incomplete. This is a step-by-step guide to actually working through the calculation in an interview setting.
Why This Question Trips People Up
Debt is cheaper than equity, and interest is tax-deductible — so adding debt to the capital structure should, all else equal, pull WACC down. But adding debt also increases the risk borne by equity holders, which raises the (relevered) beta, cost of equity, and — beyond a certain point — the cost of debt itself as lenders demand more compensation. The real answer is that WACC's response to leverage depends on which effect dominates, and the only way to know is to actually run the numbers.
Step 1: Start With the Current Beta and Capital Structure
You need the company's current levered beta, its current debt-to-equity ratio, and its tax rate. If you're working from comparable companies rather than the target's own beta, you'd first unlever each comp's beta and average the unlevered betas — that process is covered conceptually in What Is Unlevered Beta? Unlevering and Relevering Beta Explained and demonstrated numerically in Case 11.
Step 2: Unlever, Then Relever at the New D/E
Strip financing effects out with the Hamada equation:
βU = βL / [1 + (1 - T) × (D/E)]
Then rebuild beta at the proposed, higher debt-to-equity ratio:
βL(new) = βU × [1 + (1 - T) × (D/E)new]
The relevered beta will always be higher than the current beta when D/E increases — this part is not in dispute. The question is what happens next.
Step 3: Recompute Cost of Equity
Plug the new beta into CAPM:
Re = Rf + β × ERP
Cost of equity rises directly with the relevered beta. On its own, this looks like it should push WACC up.
Step 4: Recompute WACC — and Watch the Weights
This is the step interviewers are actually testing. WACC isn't just cost of equity — it's a weighted blend:
WACC = [E/(D+E) × Re] + [D/(D+E) × Rd × (1 - T)]
As D/E rises, more weight shifts onto the debt term — which is both cheaper than equity and tax-advantaged. In many realistic scenarios, this shift offsets the higher cost of equity almost completely, and WACC can end up flat or even slightly lower after a leverage increase. Case 42: WACC with Leverage runs this exact comparison with full numbers — beta relevers from 1.20 to 1.85, cost of equity jumps from 10.7% to 14.6%, and yet WACC actually ticks down slightly, from 8.4% to 8.1%.
How to Present This in an Interview
Don't just state the punchline — walk the interviewer through the mechanism: relevered beta rises, cost of equity rises, but the capital-structure weights shift toward cheaper after-tax debt, and the net effect on WACC depends on the balance between those two forces. If you want the full walkthrough of the building blocks of WACC itself before tackling the leverage question, start with Case 36: WACC: The Building Blocks.
Where This Breaks Down
This favorable trade-off doesn't hold indefinitely. At high enough leverage, credit rating downgrades push the pre-tax cost of debt up too, and distress risk starts to dominate — at that point, further leverage does increase WACC. Knowing where that inflection point roughly sits, even qualitatively, is what separates a strong answer from a mechanical one.