Ivo Welch

In a Modigliani-Miller (M&M) perfect capital market, the overall WACC remains the same regardless of capital structure. Mathematically, a capital structure with more leverage has a higher cost of debt and a higher cost of equity but tilts the weighting from higher-cost equity towards lower-cost debt. Of course, the Modigliani-Miller world is primarily a thought experiment.

When the capital markets are not perfect, firms can minimize their WACC by choosing the best capital structure—the one that minimizes their tax obligation, moral hazard and agency conflicts, adverse information disclosure, transaction costs, etc. Nevertheless, the M&M indifference prescription remains surprisingly accurate as long as debt is less than, say, half of the firm’s financing. This works because WACC tends to be very insensitive to modest levels of leverage. Put differently, it matters little whether a firm chooses a capital structure of 10 percent debt or 30 percent debt; the WACC typically remains about the same.

Fine-tuning their optimal choice of leverage really matters only for firms that are high-leverage (say, 80 percent or more), such as financial services firms, firms near financial distress, or firms in leveraged buyouts.

Of the three effects of leverage (higher CC on debt, higher CC on equity, more weight on the debt component) only the first and last remain. The WACC then decreases as long as the expected rate of return on marginal debt remains below the expected rate of return on equity. Managers can thus obtain the lowest WACC with a capital structure in which the expected rate of return on debt is equal to the (roughly constant) expected rate of return on equity on the margin. (The average cost of capital on debt should be lower.)

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