Topic:
Is cost of debt higher or cost of equity? Explain why.
PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:
A company can obtain capital either through issuing debt or equity. Each of them has its own cost. Discuss which one has a higher cost for company and why.
Post 1
by Ngoc Dinh Learning Engagement # 5 Topic: Is cost of debt higher or cost of equity? Explain why. A company can obtain capital either through issuing debt or equity. Each of them has its own cost. Discuss which one has a higher cost for the company and why. There are two main sources of capital companies rely on—debt and equity. Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each also comes with a cost. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company’s profit margins. Debt is also cheaper than equity from a company’s perspective is because of the different corporate tax treatments of interest and dividends. In the profit and loss account, interest is subtracted before the tax is calculated; thus, companies get tax relief on interest. Cost of Debt Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection. Debt capital does not dilute the company owner’s interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising. Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company’s list of priorities over annual returns. While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble (Boyte-White, 2021). Cost of Equity Equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. Equity funds don’t require a business to take out debt which means it doesn’t need to be repaid. But there is some degree of return-on-investment shareholders can reasonably expect based on market performance in general and the volatility of the stock in question. Companies must be able to produce returns—healthy stock valuations and dividends—that meet or exceed this level to retain shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta value of the company’s stock to determine the expected rate of return or cost of equity (Watson & Head, 2013). References. Boyte-White, C. (2021). How Do Cost of Debt Capital and Cost of Equity Differ? BUSINESS. CORPORATE FINANCE & ACCOUNTING. Investopedia Watson, D., Head, A. (2013). Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall492 words
Post 2
by Jana Kmetova Thakur (n/A) describes the cost of debt as the expected rate of return for the debt holder. It is usually calculated as an effective interest rate that can apply to a company’s liability. In addition, it is an internal par of discounted valuation analysis that calculates the company’s present value by discounting future cash flows by the expected rate of return to its equity and debt holders. Usually, the cost of debt can be calculated before or after taxes; the total interest expense upon total debt availed by the company is the expected rate of return and can be incurred by a company in any year it is before. The cost of debt calculation must include:Total interest cost.Aggregate debt (at the end of the fiscal year).The tax rate (the average rate that the company is taxed). Mukhopadhyay (n/a) states that the cost of equity calculates the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; in addition, it may go to other opportunities with higher returns. For instance, if we have $1000, we would invest them into the company ABC, which has a low-risk stock. The company’s current stock price is $8, with an expected rate of return for us would be 15%. By calculating the cost of equity, we will know that we can get 15% or more if we invest in the company. If not, we can find other investment opportunities.In general, the cost of equity is higher than the cost of debt. The reason is that investors take more risk when investing in a new company stock compared to investing in the company’s bond. Other reasons can be – Capital gains are not a guarantee, a company has no legal obligation to issue dividends, and the stock market has higher volatility than the bond market. On the other hand, it can happen that cost of debt can be higher. It happens when the company has too much debt, which raises the cost of debt over equity. The main factor that influences the cost of debt is the interest rate (CFI, 2021). References:Thakur M. (n/a). What is Cost of Debt (Kd)?, https://www.wallstreetmojo.com/cost-of-debt/?nowpr…Mukhopadhyay S. (n/a). Cost of Equity, https://www.wallstreetmojo.com/cost-of-equity-capm…CFI. (2021). Debt vs Equity Financing: Which is best?, https://corporatefinanceinstitute.com/resources/kn…436 words
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