Ask Experts Questions for FREE Help !
Ask
    tanka's Avatar
    tanka Posts: 1, Reputation: 1
    New Member
    		  
    #1

    Dec 9, 2007, 05:22 PM
    Cost of Equity Capital & Cost of Debt capital
    Hello everyone,

    Can you explain me why the cost of equity capital almost always or theoretically should exceed the cost of debt capital?

    Thanks,
    Tanka
    Ren Radio's Avatar
    Ren Radio Posts: 31, Reputation: 6
    Junior Member
    		  
    #2

    Dec 10, 2007, 05:12 AM
    Quote Originally Posted by tanka
    Hello everyone,

    Can you explain me why the cost of equity capital almost always or theoretically should exceed the cost of debt capital?

    Thanks,
    Tanka
    Every investor wants to see skin in the game. Period.
    mad1989's Avatar
    mad1989 Posts: 1, Reputation: 1
    New Member
    		  
    #3

    May 28, 2009, 08:22 PM

    A company has a target structure of 40% debt and 60% equity. The yield to maturity on the company's outstanding bonds is 9% and the company's tax rate is 40%. The company's WACC is 9.96 %. What is the company's cost of equity capital?
    ArcSine's Avatar
    ArcSine Posts: 969, Reputation: 106
    Senior Member
    		  
    #4

    Jun 6, 2009, 09:26 AM
    Tanka, in both cases (cost of equity, cost of debt), the "cost" of the paper reflects the return the holder (shareholder, in the case of equity; lender or bond investor in the case of debt) demands from the investment.

    With that in mind, it's reasonable that equity holders will almost always demand a higher yield than a lender or bond investor. Think of the risk-reward relationship. If things go bad and assets have to be divvied up, lenders go right to the head of the line, while the common equityholders wait outside in the rain, hoping for some leftovers.

    Lenders enjoy various priorities over shareholders in certain legal respects, and so in general, lenders are holding "safer" paper than stockholders. Hence, they're happier with a lower return that what the shareholders demand.

    OK, we've got a common-sense rationale for an equity vs. debt disparity. Now factor in the tax-deductibility of interest expense on debt. In many (but not all) cases, the return paid by the company to its bondholders reduces the company's tax liability, whereas the dividends paid to its shareholders does not. In effect, this serves to make the debt paper even cheaper, on an after-tax basis, than the equity.

    It's a deep and interesting topic, and this barely scratches the surface, but I hope it helps for starters. Cheers!

    ...it was early and I was full of no coffee...
    morgaine300's Avatar
    morgaine300 Posts: 6,561, Reputation: 276
    Uber Member
    		  
    #5

    Jun 7, 2009, 12:54 AM

    mad1989, please start your own thread for your question. Or better yet, put it over in homework help since that's what it is. And then read our guidelines on posting homework problems:
    Ask Me Help Desk - Announcements in Forum : Homework Help
Not your question? Ask your question View similar questions
 

Question Tools Search this Question
Search this Question:

Advanced Search

Add your answer here.


Check out some similar questions!

Finance / cost of equity and weighted average cost of capital [ 2 Answers ]

How do I go about calculating the after-tax cost of new debt and common equity. Calculate the cost of equity and calculate weighted cost of capital. I do not understand this a bit. The following tabulation gives earnings per share figures for the Foust Company during the preceding 10 years. The...

Capital Budgeting and opportunity cost of capital [ 1 Answers ]

Wiley Co. is considering an investment of $200,000 in a project with a 5 year economic life. After tax net income from the project has been calculated at $22,00 per year including a deduction for depreciation of $30,000 per year. The residual or salvage value at the end of 5 years is $50,000....

Debt Equity & Cost of Capital [ 1 Answers ]

McCoy, Inc. has equity with a market value of $40 million and debt with a market value of $20 million. The cost of the debt is 6 percent semi-annually. Treasury bills that mature in one year yield 5 percent per annum, and the expected return on the market portfolio over the ...

View more questions Search