Question

As debtholders rank ahead of shareholders, it is expected that the required rate of return on debt will be higher than the required rate of return on shares. Discuss the validity of this statement.

Answer 1

The given statement is FALSE because the required rate of return on equity will always be higher than the required rate of return on debt, because required rate of return on debt is highly secured from secured payment in form of interest by the company and these are also senior debt and they will be paid before the payment to the equity shareholders and hence these payments to the debt holders are fixed in nature and it is the obligation of the company to fulfill the return and there is a lower risk so there will be a lower required rate of return because risk and return are directly correlated.

Equity shareholders are having the residual claim on the Assets of the company and hence they are exposed to the most amount of systematic risk associated with their investment and so they will be having a higher required rate of return because they will be having a higher systematic beta and hence the required rate of return is higher because the risk is higher and there will be a direct correlation between risk and return and hence the overall required rate of return of equity shareholders will be higher than that of debt holders.