WACC Calculation and Capital Structure: Optimal Leverage & Pecking Order

Posted on Jan 11, 2026 in Economy

Weighted Average Cost of Capital (WACC)

WACC = the weighted average cost of the financial resources used by a company or project after taxes. It represents what it costs the company to obtain financing. It combines the cost of debt and the cost of equity (what shareholders require), weighted according to the proportion that debt and equity have in the capital structure.

CAPM Assumptions

  • Perfect markets (perfect competition, free information for all investors, and no transaction costs).
  • Homogeneous expectations (all investors have the same expectations for future returns).
  • Investors are rational (decisions based only on risk and return).
  • One risk-free rate (available to all investors).
  • No taxes (on capital gains, dividends, or interest).
  • All investors are price takers (individual investors do not affect market prices).
  • Assets are divisible.
  • Constant correlation between securities over time.

Determination of Financial Sources

Companies must choose the financing option that maximizes shareholder value. Two main theories explain how firms decide their capital structure:

1. Static Equilibrium Theory (Optimal Leverage)

This theory states that there is an optimal level of debt that maximizes the firm’s value.

  • At first, increasing debt reduces WACC because debt is cheaper than equity and interest is tax-deductible.
  • If debt keeps increasing, financial risk and expected insolvency costs rise. As a result, banks demand higher interest rates → cost of debt increases; shareholders require higher returns → cost of equity increases → WACC increases.
  • The optimal leverage is the point where the tax benefits of debt and the additional risk are balanced, leading to the minimum WACC.

2. Pecking Order Theory

Firms follow a hierarchy of financing sources, based on cost and information asymmetry:

  1. Retained earnings: no explicit cost, no dilution, no negative market signals.
  2. Debt: tax-deductible interest and less signaling impact than issuing equity. Used after retained earnings.
  3. Equity (capital increases): causes dilution, may send negative signals, and is usually more expensive.

Weighted Average Cost of Capital (WACC)

WACC = the weighted average cost of the financial resources used by a company or project after taxes. It represents what it costs the company to obtain financing. It combines the cost of debt and the cost of equity (what shareholders require), weighted according to the proportion that debt and equity have in the capital structure.

CAPM Assumptions

  • Perfect markets (perfect competition, free information for all investors, and no transaction costs).
  • Homogeneous expectations (all investors have the same expectations for future returns).
  • Investors are rational (decisions based only on risk and return).
  • One risk-free rate (available to all investors).
  • No taxes (on capital gains, dividends, or interest).
  • All investors are price takers (individual investors do not affect market prices).
  • Assets are divisible.
  • Constant correlation between securities over time.

Determination of Financial Sources

Companies must choose the financing option that maximizes shareholder value. Two main theories explain how firms decide their capital structure:

1. Static Equilibrium Theory (Optimal Leverage)

This theory states that there is an optimal level of debt that maximizes the firm’s value.

  • At first, increasing debt reduces WACC because debt is cheaper than equity and interest is tax-deductible.
  • If debt keeps increasing, financial risk and expected insolvency costs rise. As a result, banks demand higher interest rates → cost of debt increases; shareholders require higher returns → cost of equity increases → WACC increases.
  • The optimal leverage is the point where the tax benefits of debt and the additional risk are balanced, leading to the minimum WACC.

2. Pecking Order Theory

Firms follow a hierarchy of financing sources, based on cost and information asymmetry:

  1. Retained earnings: no explicit cost, no dilution, no negative market signals.
  2. Debt: tax-deductible interest and less signaling impact than issuing equity. Used after retained earnings.
  3. Equity (capital increases): causes dilution, may send negative signals, and is usually more expensive.