Why might a company with high leverage experience a higher WACC?

A company with high leverage experiences a higher Weighted Average Cost of Capital (WACC) primarily because higher leverage increases financial risk. When a company takes on more debt, it becomes more financially risky for both equity and debt holders.

As a company becomes more leveraged, the likelihood of default on its debt obligations increases, especially in times of economic downturns. This heightened risk leads lenders to demand higher interest rates to compensate for the increased probability of default, thereby increasing the cost of debt. Additionally, equity investors will also require a higher return to compensate for the added financial risk they incur as the company's leverage rises. They recognize that a highly leveraged firm may struggle more in challenging financial environments, driving up the cost of equity.

In essence, high leverage amplifies the risk faced by both equity and debt holders, necessitating a higher overall required return, which in turn raises the WACC.