The structuring of financing is a central issue in corporate finance. Intuitively, one might think that replacing equity (costly because it is risky for the shareholder) with debt (cheaper because it is lower risk for the creditor and deductible interest) mechanically reduces the Weighted Average Cost of Capital (WACC).

However, based on the work of Modigliani and Miller, this idea must be strongly qualified. If the nominal cost of debt is lower than the cost of equity, the increase in debt increases the financial risk borne by shareholders. As a result, the latter require higher profitability (via the increase in the beta of equity, formalized by the Hamada formula). This increase in the cost of equity almost fully offsets the benefit of the lower cost of debt.

The only real lever for value creation linked to debt comes from taxation: loan interest is deductible from taxable income, which means that the State subsidizes part of the cost of the debt. Thus, the WACC decreases slightly with debt thanks to this “tax leverage effect”.

However, there is no simple mathematical optimum. The WACC curve as a function of debt is relatively flat over a wide range. Beyond a certain threshold, the cost of debt increases (risk of bankruptcy perceived by creditors), which raises the WACC.

More importantly, the sources emphasize the importance of financial flexibility. Voluntary under-indebtedness (having less debt than the optimal theoretical level) can be a value-creating strategy. By maintaining a “debt capacity reserve”, the company keeps the possibility of seizing major strategic opportunities (such as a large rapid acquisition, cf. the example of Danone or L’Oréal) that over-indebted competitors could not finance. Under-indebtedness is therefore perceived as a real growth option whose cost (a slightly non-optimized WACC) is the premium to be paid for strategic flexibility.