Question

Debt generally has a lower cost of capital to a company, due to lower flotation costs, lower risk taken by debt holders and benefit of a tax shield received from writing off interest expense on a corporate's income statement.

Answer 1

There are majorly two components in the Capital Structure namely Debt and Equity. Debt is the outside loans whereas Equity is the owner’s fund. We know that debt is taken from outside the company and hence it involves risk of repayment. On the other hand, equity is the funds generated from the owners and hence involves very low risk. We can therefore say if the capital structure has higher debt percentages then it will be riskier for the company to consider a project and vice versa. Cost of debt is calculated post-tax. Interest is paid on debts and we always pay corporate tax on interest. So, we calculate cost of debt after tax. Equity is the shareholders’ capital and we compute the return of the equity from the dividends which is already post tax. So we do not require considering tax again for the cost of equity. Cost of equity is hence higher than the cost of debt. From this we can clearly conclude that the higher is the debt in the company the lower will be the cost of capital and the lower is the debt in the company the higher will be cost of capital. Debt and cost of capital move in the opposite direction. Although taking debt is riskier for the company but it also reduces the overall cost of capital of the company.

Use of debt increases the risk of repayment of principal and interest and interest on debt and subsequently it increase rate of return required by shareholders.For 100% equity financed firm, shareholders only face business risk which is captured by unlevered beta.