Question

compare average yield .85 of CVS long-term debt with the cost of equity7.6 and comment on the difference. IN general you should ovserce that expected return of debt is lower than expected return of equity, in another word, cost of devt is cheaper than cost of equity.

Answer 1

Debt providers of a firm are assured a return equal to the principal and interest. Thus even in the event of bankruptcy, debt providers will be first to be repaid and only if there are funds pending after paying off the debt providers, will the equity providers be paid. Also the return the equity provider gets is uncertain. If the corpus left behind after paying the debt providers is high, the equity providers gain is high. If this corpus is low, the gain of equity provider is less. Thus from a risk point of view, the risk associated with debt providers is less than the risk for equity providers. Everything operates one risk return tradeoff. Higher the risk, higher is the expected return from any activity. In this scenario, debt providers have lesser risk when compared with equity providers. Thus the return expected for a debt provider is less than what is offered to a equity provider simply because the equity provider needs to be compensated better for the increased risk the equity provider is taking.

Thus cost of debt is cheaper than cost of equity.