Question

Which is lower for a given company: the cost of debt or the cost of equity? Explain. Ignore taxes in your answer. Include a discussion of the risk-return relationship and how this factors into an investor's decision to select and investment for their portfolio.

Answer 1

• In my opinion , Cost of debt is lower than cost of equity , in a given company .

• Reasons are as follows in detail

• The company having large number of debt attempts to issue shares , to fund itself , then cost of equity is high and there will be expected dividends and share appreciation.

• If we compare cost of debt with cost of equity , then we have to consider how interest on loan of a company pays , compare to profit which an owner sacrifices over the lifetime of company . If the interest payable by the company is less than an outside investor's cut of the company profit , then debt is less expensive and vice versa .

• If the cost of debt is finite and there is no any obligations for the company in the name of lendor once the loan is totally repaid, thus debt is cheaper than equity for the profitable companies .

• We can say , may be debt is secured , but not always , if the company failed to provide interest on loan , then the lendor will be able to sell company assets to recover the money they lent the company.

• Equity holders have residual claim on company assets , once their obligations of company have been satisfied .

• Equity holders have high risk , sometimes will be additional risk to sacrifice , if company failed . So they demand higher return from company .

• Company have certain limit for holding debt , because more debt may cause for higher risk for them . Additional debt may leads to over leveraged .

• Anyway , we can say that debt is more cheaper source of financing , than equity .this is not always possible , may depending company 's financial stability and other factors .

Introduction to cost of debt and cost of equity :

• all business needed capital for their survival .capital may be used to pay off debt , conducting market research , to make investment ...etc .

• mainly 2 source of capital are there , as equity and debt . both are needed for the growth of the company .

• dept capital is the borrowed fund that must be repaid at later along with principal plus interest amount . these loans may be long term or , short term such as overdraft protection .

• company has liability to repay its interest before providing dividend to equity holders . it makes dept capital have higher priority over annual returns .
• debt allows to leverage a small amount of money in to more greater sum , lenders typically needed payment of interest in return . this interest is termed as the cost of debt capital of the company .
• this interest is deductible one, which is more useful to determine the company s after tax cost of debt .

• cost of debt is useful to asses company s credit situation and when combined with debt size , it can be a good indicator for over all financial health .

• cost of debt with cost of equity make up the company s total cost of capital .

• equity capital :

• its the fund invested by the share holders . its cost is slightly more complex .  

• equity does not be repaid as debt . but , there is return on investment , a share holder can expect based on market performance and the volatility of the stock .

• company must provide return as they have possible , to retain share holder investment .

• Capital Asset Pricing Model ( CAPM ) utilizes risk free rate, risk premium of wider market , and beta value of company s stock , to determine expected rate of return or cost of equity .

• thus , cost of equity exceeds the cost of debt .

• their risk is greater than debt holders since payment on debt is required by law regardless of a company s profit margins .

• equity may in , following forms :

• 1. common stock : the company sell common stock to raise cash . common shareholders can vote on certain company matters .
• 2. preferred stock : it will not give voting right . but does grant ownership in that company . they will get amount of payment before common share holders get , in case the business is liquidated .

Risk - Return Relationship in a capital structure

And risk in both debt and equity , return in both :

• The capital structure decisions are related with proportion of debt ( risk ) to equity ( return ) .

• even though debt is cheaper , its more risky to the company due to payment of interest and return of principal , which is obligatory to them .

• if there is any default in meeting such commitments , it may force the company in to liquidation .

• but , there is no such compulsion for equity . so , its risk less to company .  

• thus , debt in total capital generates more return for equity holders , as interest payments on debt is deductible from earning before tax payment .

• so , capital structure decisions affect both risk and return . thus , capital structure decision is the optimization of risk return relationship .

• risk of debt capital and equity capital to companies are as follows :

• debt repayment risk :

  in debt capital , its must to pay interest periodically . if a company is failed to pay this amount , then , may lead to bankruptcy .

• risk of being underfunded :

  when there is more debt in a company , it may lead to higher risky and also when company raises additional capital , which can prevent them from getting cash it requires if it gets in to bind . as example , if your small business has more debt , then new investors or lenders strictly deny your request for more money , so you limited the ability to operate .

• loss of ownership :

  if a company raises more equity , it risks losing control of company . example is , if your small company selling 60% stake in that to investor ,he must try to take over that company , if he unsatisfied with company performance .

• missing the growth opportunities :

  if a company , especially a small business in a growth phase needs to reinvest majority of its profits into its business rather than distributing it as dividends . if company provides too much amount as dividend , it reduces the growth opportunities of them .

• 2 reasons , why the company should use debt to finance a large part of the business :

  1. govt. encourages debt capital due to its interest , which are deductible from corporate income taxes.

2. debt is more cheaper than equity . and there is no obligation to pay dividend to equity holders , but interest to debt holders is obligatory to company which are less risky than equity to the company . equity return is tied up with share appreciation which needs a company to grow revenue , profit and also cash flow . so the investor needs at least 10% return , while debt at a lower rate .

• thus, debt is lower source of fund and allow huge return to share holders by leveraging their money .

equity risk :

its the financial risk included in holding equity in a particular investment .

the measure of risk in equity market is standard deviation of security price over number of periods . it will delineate normal fluctuations one can expect in that particular security above and below the mean , or average .

if there is high risk , then there will be higher or excess return in equity market , which is termed as equity risk premium .

• risk return trade off :

  it states that , potential return will rise with an increase in risk . using this principle , there is low level of risk with low potential return and vice versa . according to this trade off , invested amount can render high profit only if the investor will accept high loss . investors are using this , as a good component of each investment decision and to construct good portfolio .

• thus , we can say that cost of debt is low and will get interest , even if there are no profit in the company . but equity is costly , not needed to pay dividend if , not profit . they are payable only after paid to debt holders . even though , when takes high risk , there is higher return and vice versa .

• so , in my opinion , cost of debt is lower than cost of equity and it will give a stable return . not needed to make more tension .the interest payment to debt holders are lower than equity return , its must to say that cost of debt is lower .

How risk return factors will affect an investor while selecting and investment decision of their portfolio :

• each portfolio have its own risk return features . a portfolio comprising securities with maximum return for a given risk , its termed as efficient portfolio

• portfolio risk is a risk , that combination of assets , within the investment you owned , failing to meet financial objectives . so it may be high risk with high potential return .  

• return from investment is the amount of profit in terms of percentage of initial investment . and risk is the possibility that your amount of investment will loss . x

• historical return on investment is the annual return of invested assets over many years . it will help to estimate future rate of return .

• we can use actual result with estimated one to evaluate various assets. this evaluation process helping to pick good mix of securities to maximize return in your investing time period .  

• risk factors includes market volatility , inflation , deteriorating business fundamentals . and financial market downfall will affect asset prices . inflation leads to lowering purchasing power , high cost and low profit to the company .

• a weak business fundamentals leads to low profit , losses and eventually a default in debt obligation .

• Risk and return :

  We cannot completely eliminate risk , but can manage by diversified portfolio of stocks , bonds and others .portfolio composition is consistent with our financial objectives and risk tolerance .high return will get for high risky assets .

• Example is : savings account, certificates of deposits , Treasory bonds have lower return , and are safe investments . But long term return are getting for only growth stocks and risky assets .

• Consideration of investment decisions : there is need of adjusting asset mix while planning for a good portfolio.an example is ,

• Your stock value in portfolio is high at starting period , because you can afford to take high risks and to grow your investments quickly .

• But , your starting portfolio may change , that to be balanced mix of stocks plus bonds when you starting a family .

• At last , you will switch to more bonds and dividend paying stocks , if you near to retire .

• There is needed the market movements which required for periodic portfolio adjustments .example is , taking some profit in stock follows a sharp market rally or investing in quality stocks at bargain prices after sharp market correptions

Hope you understand answer in detail.

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