Question

The text discusses the concepts of Cost of Debt and the Cost of Equity. Discuss with your class colleagues your understanding of each and if you were to acquire a new asset, which one would you prefer to use to pay for the asset and why.

Answer 1

The cost of debt is the rate of return demanded by the debt holders for providing capital in the form of debt to the company.

The cost of debt can be calculated as the yield to maturity of a given debt.

The cost of equity is the return required by the investors for providing investment in the form of equity to the company. The cost of equity can be calculated using the CAPM model,

Re = Rf + beta(Rm - rf)

Where Re = cost of equity

Rf is the risk free rate

and (Rm - rf) is the market risk premium

As the debt holders have to be repaid the amount of investment made by them, irrespective of the company making profits or not due to the safety provided to the debt holders, the cost of debt is generally low.

The cost of equity is high in comparison to the cost of debt as the investors may or may not recieve the money invested by them back from the company but they recieve a share of ownership within the company.

If i were to acquire a new asset, i would choose debt over equity due to the debt being cheaper but if my company already has too much debt , then i would raise more capital through equity.