Tuesday, August 16, 2011

Blackboard notes: Cost of Debt vs Cost of Equity

A business entity raises capital primarily by two means--putting its own money or by taking loans from the bank or from the creditors. The capital raised through loans is categorized under the debt fund of the capital structure. While it may not be advisable to have all the capital requirements from the debt, for obvious reasons such as repayment of loans and interests within a short period of time , and the risk of losing the credibility in the market.
Owners equity is another source of funds for a company, which includes the money contributed by the founders, as well as the share capital ,which is the capital raised from the public by giving them ownership shares in the company itself.
Thus there are often two sources of Funds ,in the balance sheet : Share capital and debt,loans/ debentures.These are categorized under the liabilities.

One question that often arises is : which is more expensive? Equity or Debt .
Suppose a company wants to raise $ 100 dollars, should it issue 10 shares of $ 10 face value or should it take a loan from the bank at 10% rate of interest ?This is a hypothetical situation. The cost of debt here is the interest rate that the bank charges on $100 .
The cost of Equity on the other hand is the returns + risk premium . CAPM model is used to calculate the returns from a commpn stock.It links the Risk free rate, the risk premium and the beta or the risk factor of investing in a particular stock.
The formula for the cost of equity can be written as:

Cost of Equity = ((Dividend for Next Year + Stock Price Appreciation) / Current Share Price)) + Dividend Growth Rate
There are advantages/disadvantages of having debt financing/ Equity financing.
While equity financing dilutes the ownership rights in a company ,but on the other hand, there is no obligation to repay it in short term. Equity financing is however more expensive qualitatively, because unlike debt, Equity is not tax deductible and while debt is returned along with a fixed rate of interest charges, Equity is returned in proportion to the profits. The more the profit, the more has to be the dividends paid.
Equity holders also claim ownership rights in the company.

The ideal capital structure is evaluated using the WACC model or the weighted average cost of capital.
The model considers the D/E ratio, Interest coverage ratio and EBITDA to compute the ideal capital structure for any company. The default risk spread is used to rate the company on the basis of above parameters to assess the ability of the firm to repay debts. This way a company can decide the ratio of debt and equity in its capital structure.

Different industries have different D/E requirements and standards. A newly launched company might consider having more of equity financing,since it is unsure of its performance.


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