What happens to WACC when a company surpasses its optimal capital structure with too much debt?

When a company exceeds its optimal capital structure by taking on excessive debt, the Weighted Average Cost of Capital (WACC) starts to increase due to the increased risk associated with higher leverage. The reason for this increase is that as a company relies more on debt financing, the financial risk to equity holders also rises. This phenomenon occurs because debt increases the likelihood of financial distress, which can lead to higher costs of equity as shareholders demand a higher return for bearing this additional risk.

Moreover, when the capital structure becomes overly skewed toward debt, the cost of debt can also rise, partly due to lenders demanding higher interest rates to compensate for the increased risk of default. As a result, the benefits of taking on low-cost debt can diminish when too much debt is used, leading to a higher overall WACC. Thus, while borrowing can initially reduce WACC due to the tax deductibility of interest payments, going beyond the optimal point shifts the balance and ultimately makes financing more expensive due to the associated risks.