Final answer:
The removal of all debt from a company that formerly used 20% debt in its capital structure will likely increase its WACC due to the elimination of the cheaper cost of debt. This decision might be rational in terms of reducing financial risk, but it can potentially lead to a higher cost of capital and a lower valuation.
Step-by-step explanation:
When a company that previously had a capital structure of 20% debt and 80% equity pays off all its debt, its Weighted Average Cost of Capital (WACC) will change. WACC is calculated using the costs of both equity and debt, where each is weighted based on its proportion in the company's capital structure. Since debt is typically cheaper than equity—due to tax deductibility of interest and it being less risky for investors—the company's WACC is likely to increase when the debt is removed from the capital structure entirely.
Paying off debt can be a rational decision as it simplifies the company's finances and can reduce financial risk, but it might not always maximize shareholder value due to an increased cost of capital. The irrational behavior described in the provided information, where individuals value savings account balance over paying down debt despite the lower net worth, is a form of cognitive bias known as mental accounting.