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

Quote:

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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

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Every investor wants to see skin in the game. Period.

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?

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...

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:
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