Question

Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable, financially healthy, profitable, tax-paying firm that has been financed with all equity and no debt decides to add a reasonable amount of debt to its capital structure. What effect will that change in capital structure likely have on the firm’s weighted average cost of capital?

Answer 1

Return on equity is considered as a residual return, which means that, whatever income or return is achieved by the company, first it is distributed among the debt holders and preferred stock holders. And what ever is left after this, then this left out or residual is distributed among equity stock holders. So people prefer a consistent return rather than risky higher return.

Also, debt financing is cheaper than equity financing. Also, in the event of liquidation, stock holders are liable to contribute. This is not the condition in debt financing.

Suppose, a stable , financially healthy, profitable, tax paying firm financed with all equity and no debt decides to add a reasonable amount of debt to its capital structure, then the company's weighted average cost of capital is decreased from it's present wacc, because debt is less costly than equity. And also, tax benefit is given on interest payment of debt. Overall, it results in reduction of WACC.