WACC with Leverage

Step 1: Unlevered Beta

βU = βL / [1 + (1 - T) × (D/E)]

Plugging in the current beta (1.20), tax rate (25%), and current D/E (0.50):

βU = 1.20 / [1 + (1 - 0.25) × 0.50] = 1.20 / 1.375 = 0.87

Unlevered beta strips out the effect of the company's own financing choices, leaving only the risk of the underlying business. It's the beta you'd compare across companies with different capital structures, or use as a starting point before relevering to a different D/E ratio — exactly what happens next.

Step 2: Relevered Beta at the Proposed D/E

βL(new) = βU × [1 + (1 - T) × (D/E)new]

Plugging in the unlevered beta (0.87) and the proposed D/E (1.50):

βL(new) = 0.87 × [1 + (1 - 0.25) × 1.50] = 0.87 × 2.125 = 1.85

Relevering shows how much riskier the equity becomes as more debt enters the capital structure: fixed interest payments make earnings to equity holders more volatile, which pushes beta — and therefore the required equity return — higher.

Step 3: Cost of Equity at Each Leverage Level

Re = Rf + β × ERP

Where: Rf = Risk-Free Rate, β = Levered Beta, ERP = Equity Risk Premium.

At the current leverage (β = 1.20):

Re(current) = 3.5% + (1.20 × 6.0%) = 3.5% + 7.2% = 10.7%

At the proposed leverage (β = 1.85):

Re(proposed) = 3.5% + (1.85 × 6.0%) = 3.5% + 11.1% = 14.6%

Cost of equity is the return shareholders demand for bearing the company's risk. It rises with leverage because equity absorbs the volatility created by fixed debt payments — the more debt in the structure, the more compensation equity investors require.

Step 4: WACC at Each Leverage Level

WACC = [E/(D+E) × Re] + [D/(D+E) × Rd × (1 - T)]

Where: E/(D+E) and D/(D+E) are the capital-structure weights, Rd × (1 - T) is the after-tax cost of debt.

At the current D/E of 0.50 (E = 1.0, D = 0.5, so E/(D+E) = 66.7% and D/(D+E) = 33.3%):

WACC(current) = (66.7% × 10.7%) + (33.3% × 5.0% × (1 - 0.25)) = 7.1% + 1.25% = 8.4%

At the proposed D/E of 1.50 (E = 1.0, D = 1.5, so E/(D+E) = 40.0% and D/(D+E) = 60.0%):

WACC(proposed) = (40.0% × 14.6%) + (60.0% × 5.0% × (1 - 0.25)) = 5.9% + 2.25% = 8.1%

Even though beta — and therefore the cost of equity — rose sharply with leverage, WACC barely moved, and even ticked slightly lower. This is the tax shield effect at work: debt is cheaper than equity and interest is tax-deductible, so shifting weight toward debt can offset the higher required return on a riskier equity slice. It's why "more leverage always increases WACC" is a common but incorrect assumption in interviews.

Final Results

• Unlevered Beta: 0.87
• Relevered Beta at Proposed D/E: 1.85
• WACC at Current Leverage: 8.4%
• WACC at Proposed Leverage: 8.1%

This relevering technique is the same mechanic used to build a comparable-company beta for a DCF: unlever peer betas to strip out their financing, then relever at the target's own capital structure before plugging the result into CAPM and WACC.

Would you like to see the D/E ratio at which WACC is minimized, or explore how a credit rating downgrade at high leverage would change the cost of debt assumption?