“The cost of equity can never be cheaper than the cost of debt considering an equity...

“The cost of equity can never be cheaper than the cost of debt considering an equity investor is the last taker of funds, should the worse come to worst for the issuer. And he requires compensation for such risk”.

Critically evaluate the remark above from the viewpoint of global finance.

Expert Solution

In equity financing, companies obtained funds in exchange of ownership of company. The firms sell their shares (ownership stakes) in the proportion of funding obtained. The Equity holders share profit as well as losses of the company like an owner. But in debt financing, company borrows fund and pays fixed amount of interest and repay principal amount in scheduled manner. The debt financers do not have any other claim on the company.

Equity holders have residual claim on the profit of the company as they have claim on the profit of the company after paying all other liabilities like interest to debt, taxes and dividends to preferred stock holder. They also have to bear the risk of loss if the company is not performing well and making losses so they participate in ups and downs of the company and can share profit after debt claim are satisfied. Therefore the risk is less for debt holders as they get fixed amount of payment irrespective of the performance of the company and after liquidation of the company, they get preference over equity holders for their claim on the company. Therefore the cost of equity can never be cheaper than the cost of debt considering an equity investor is the last taker of funds, should the worse come to worst for the issuer. And therefore equity investor requires compensation for taking such risk.

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“The cost of equity can never be cheaper than the cost of debt considering an equity...

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