How to Answer “What factors drive WACC up or down?” in Investment Banking Interviews

Open by anchoring WACC as a weighted average of equity and after-tax debt:

• (\text{WACC} = \frac{E}{D+E} \cdot r_e + \frac{D}{D+E} \cdot r_d \cdot (1-T))

Then state the three levers clearly:

1. Cost of equity (r_e)
2. After-tax cost of debt (r_d(1-T))
3. Weights (E/(D+E)) and (D/(D+E))

Directionally, WACC goes up if either component cost rises or if the weighting shifts toward the more expensive source of capital (usually equity), and it goes down when those inputs fall—but you’ll caveat that changing leverage often changes the component costs too (not just the weights).

For WACC components explained for analysts, keep cost of equity intuitive and tied to CAPM:

• (r_e = r_f + \beta \cdot \text{ERP}) (plus any relevant country/size premia depending on context)

WACC rises when risk-free rates (r_f) rise (higher base rate) or when the equity risk premium widens (risk-off markets). Company-specific drivers push WACC up when beta/business risk increases—more cyclical demand, higher operating leverage, customer concentration, or higher financial leverage (equity becomes riskier as residual claim).

This is the clean way to address the impact of market conditions on WACC: even if operations are unchanged, a rates move or risk sentiment shift can change the discount rate you’d use in valuation.

Frame the cost of debt as a base rate plus a credit spread. WACC moves up when the spread widens due to weaker credit quality: higher leverage, lower interest coverage, more volatile cash flows, fewer hard assets, covenant pressure, or tighter lending markets.

Then call out the tax shield cleanly: WACC uses after-tax debt cost (r_d(1-T)). If the effective tax rate is higher, the tax shield is larger and the after-tax cost of debt is lower (all else equal), which can pull WACC down. If tax rates fall or interest deductibility is constrained, the shield shrinks and WACC can move up.

In practice, this is the quickest analyst linkage: spreads up / credit down → WACC up; tax shield larger → WACC down, holding risk constant.

Weights matter mechanically: shifting toward more debt (higher (D/(D+E))) can reduce WACC initially because debt is often cheaper than equity and tax-advantaged.

But a strong answer adds the leverage trade-off: increasing leverage can raise credit spreads (higher default risk) and also raise the cost of equity (equity volatility increases as leverage increases). Past a certain point, those increases in (r_d) and (r_e) can more than offset the benefit of heavier debt weighting, pushing WACC higher.

So in WACC analysis, treat capital structure changes as two effects at once:

• a weighting effect (more debt can lower WACC)
• a risk effect (too much debt raises both component costs)

That framing is what interviewers are looking for when asking what factors influence WACC in investment banking contexts.

Finish with what you would actually do in a model:

• If WACC changes due to markets, update risk-free rate and revisit ERP assumptions.
• If business risk changed, reassess beta (often via peer unlever/re-lever) and operating risk.
• If financing changed, update capital structure, credit spreads, and the effective tax rate assumption.

Then connect to valuation: higher WACC generally reduces DCF value because cash flows are discounted more heavily, and it often hits terminal value hardest. A good sanity check is to compare the implied WACC (and component inputs) versus peers and ensure it matches the company’s credit profile and cyclicality—exactly how to explain WACC in interviews without overcomplicating it.