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.

paragraph answer:

Answer 1

Yes, it is true that debtholders rank ahead of shareholders in case the company goes bankrupt. This means before the shareholders are paid, the company first pays the debtholders, and then if anything is leftover then the shareholders are paid.

But, the required rate of return on debt will be lower than the required rate of return on shares. As stated above debtholders have a claim on the company's assets first before shareholders are paid. For this privilage, debtholders accept a lower rate of return.

And, shareholders expect a higher rate of return for taking on the additional risk as they are the last ones to be paid after the bondholders are paid.

So, to summarise, the cost of debt < the cost of equity