“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.

Solutions

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.

jeff jeffy answered 8 months ago

Next > < Previous

Related Solutions

Generally speaking, the cost of debt is cheaper than the cost of equity. Does it imply...

Generally speaking, the cost of debt is cheaper than the cost of equity. Does it imply that a firm should increase its debt-to-equity ratio to as high as possible such that its corporate cost of capital can be minimized?

Explain three forces that can make debt cheaper than equity for corporate financing

The WACC formula implies that debt is “cheaper” than equity, that a firm with more debt...

The WACC formula implies that debt is “cheaper” than equity, that a firm with more debt could use lower discount rate. Does this make sense? Explain briefly

Debt is a cheaper source of financing than equity because Group of answer choices equityholders face...

Debt is a cheaper source of financing than equity because Group of answer choices equityholders face greater risk than creditors because of the residual nature of their claim, and they expect a higher return as compensation. interest on debt is tax deductible, but returns to owners are not. All of these are correct. debt is tax deductible, which reduces the effective cost of borrowing. Two of these are correct.

4. Cost of debt versus cost of equity. Because the cost of debt is lower than...

4. Cost of debt versus cost of equity. Because the cost of debt is lower than the cost of equity, firms must increase their use of debt as much as possible to increase the firm’s value. What is your answer to this argument?

Why would equity cost more than debt?

Questions: What are the advantages of debt over equity? If debt is cheaper, why would anyone...

Questions: What are the advantages of debt over equity? If debt is cheaper, why would anyone choose equity? How do taxes play a role in this? Assume the following for a standard bond issue within the United States: The face value of the bonds is $95,000. Stated rate on the bond is 8%. Interest is paid every 6 months (8%/2 = 4% every payment). The bonds are due in 10 years. Assume 3 scenarios, the market rate is 8%, 7%,...

It is probably easier to estimate the cost of equity than it is to estimate the cost of debt.

It is probably easier to estimate the cost of equity than it is to estimate the cost of debt.TrueFalse

It is probably easier to estimate the cost of equity than it is to estimate the cost of debt.

It is probably easier to estimate the cost of equity than it is to estimate the cost of debt.True False

A) If the cost of debt is typically significantly less than the cost of equity (especially...

A) If the cost of debt is typically significantly less than the cost of equity (especially on an after-tax basis), what do you think about the idea of capitalizing (or funding) a business entirely with debt? Explain your reasoning in 200-500 words. B) If you were a venture capitalist considering providing funding to a cash-constrained firm, what criteria could you use to assess the accuracy of their cash flow forecasts and the adequacy of their requested cash injection? Explain in...

Subjects