What effect does changing the capital structure to include more debt have on the WACC?

When a company changes its capital structure to include more debt, the overall effect on the Weighted Average Cost of Capital (WACC) is generally a decrease. This is primarily because debt is usually less expensive than equity. Since interest on debt is tax-deductible, the effective cost of debt is reduced, thereby lowering the WACC.

The rationale stems from the concepts of financial leverage and the trade-off between risk and return. As a firm utilizes more debt, it amplifies its equity returns, assuming the returns generated from its operations exceed the cost of the debt incurred. The increased proportion of debt in the capital structure ultimately lowers the average cost of financing, as debt financing, being generally cheaper than equity due to its tax benefits, contributes less to the average than equity.

Furthermore, up to a certain point, increasing debt can enhance returns due to leverage. However, it's important to note that excessively high levels of debt can lead to increased risk and cost of capital over time due to potential financial distress, which could reverse the effect. Nonetheless, in typical scenarios where debt levels rise moderately, the WACC tends to decrease.