Difference Between Cost of Debt and Cost of Equity

Edited by Diffzy | Updated on: September 21, 2022

       

Difference Between Cost of Debt and Cost of Equity Difference Between Cost of Debt and Cost of Equity

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Introduction

It is essential for any individual who wants to start a business to know about the different sources of finance from where money can be raised. The need for funds arises as soon as an entrepreneur decides to start a business. Some funds are needed immediately for the purchase of fixed assets like furniture, equipment, vehicles etc. Some funds are also required for day-to-day operations, like for purchase of raw materials, payment of salaries to employees, etc. The business also requires funds to grow, expand and diversify. Based on ownership, sources of funds may be raised from two sources- debt and equity. In the case of equity, shareholders must be paid dividends are pre-determined times of the year. In the case of debt, interest must be paid on the debt obtained. Sometimes, debt seems to be a financial burden on the enterprise as it is mandated to pay interest even if it is not earning profits. However, payment of a dividend is not compulsory. Both the sources of obtaining finance have their own merits and demerits, which need to be carefully analysed before deciding about the most suitable source for a company.

Cost of Debt vs Cost of Equity

The critical difference between the cost of debt and the cost of equity is that the former is received by debt holders of the company while the latter is received by shareholders/owners of the company. Debt is generally provided against the security of some fixed assets, while equity does not involve any form of security. The cost of debt involves the payment of interest, while the cost of equity involves the payment of dividends. Cost of debt includes repayment of the initial debt within the lifetime of the company, while equity capital is returned to shareholders only upon winding up of the company. Debt tends to be cheaper than equity, as interest payment on a debt is tax-deductible and because raising of funds through equity involves various mandatory and non-mandatory expenses like floatation cost, the appointment of professionals like brokers, underwriters, merchant bankers, issue of prospectus etc. Calculation of cost of debt does not involve any models as it is concerned with taxes, whereas the cost of equity can be calculated according to two models-dividend capitalisation model and the capital asset pricing model. Debt includes borrowings such as loans from commercial banks, issues of debentures, public deposits, etc. Equity includes capital raised through both equity shares and preference shares.

Difference Between Cost of Debt and Cost of Equity in Tabular Form

Table: Cost of Debt vs Cost of Equity
Parameters of Comparison
Cost of Debt
Cost of Equity
Definition
Cost of debt is defined as the total expenses incurred by a company to raise funds via debt. This cost includes both payments of interest and repayment of the initial borrowing.
The cost of equity may be defined as the return rate required by shareholders.
Formula
Cost of debt=r(D)*(1-t)
r(D)=pre-tax rate
(1-t)=tax adjustment
There are two models to calculate the cost of the equity-dividend capitalisation model and the capital asset pricing model.
Cost of equity by dividend capitalisation model (%)= Dividend per share (for next year)/Current market value of stock + Growth rate of Dividend
Cost of Equity by capital asset pricing model= Risk-free rate + beta of investment * market risk premium
The beta of an investment (potential) is a measure of the amount of risk the acquisition will add to a portfolio that resembles the market. If a stock is considered riskier than the market, it will have a beta greater than one. If a store has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
A market risk premium is a return expected from the market above the risk-free rate.
The risk-free rate is defined as the theoretical rate of return on investment with zero risk. It is the benchmark to measure other assets that include an element of risk.
Tax-deductible
The cost of debt is tax-deductible hence, considered to be lesser than the cost of equity.
The cost of equity is not tax-deductible. Therefore, it is considered to be higher than the cost of debt.
Rate of return
The cost of debt is determined at the rate demanded by debt holders of the company.
The cost of equity is generally the rate of return requested by shareholders.
Interest payment
Interest is paid on debt as they are borrowed funds
Interest is not paid on equity as they are owners' funds.
Dividend payment
The dividend is not paid on debt as they are not the owner's funds.
The dividend is paid on equity as they are owners' funds.
Recipient
The cost of debt is received by debt holders of a company.
The cost of equity is received by shareholders of a company.

What is the Cost of Debt?

The cost of debt is the interest that a company pays on its debts, such as bonds, debentures, and loans. Debt is a part of the company's capital structure. The capital structure of a firm deals with how it finances its overall operations and growth through different sources of funds, which may be inclusive of debt.

The cost of debt measures the overall rate being paid by a company to use debt financing. Its measures can also give investors an idea of the company's risk level as compared to others. This is because riskier companies generally have a higher cost of debt.

Formula for calculation of cost of debt

Cost of debt=r(D)*(1-t)

Where, r(D)=pre-tax rate and (1-t) =tax adjustment

Reasons for the cost of debt

Lenders need borrowers to pay back the principal amount of debt, as well as interest. This interest rate, demanded by lenders, is the cost of debt. It is demanded to compensate for the time value of money, the inflation rate expected in the future, and the risk that the loan will not be repaid. It also involves the opportunity costs associated with the money used for the loan not being used elsewhere.

Reasons for the increase in the cost of debt:

  1. Longer payback period- The payback period is the period after which a loan is repaid. A longer payback period increases the cost of debt as it increases the time value of the money.
  2. Higher risk- If the risk involved in a project is high, it will lead to an increase in the cost of debt.
  3. Loan obtained without backing it up with collateral- When a loan is obtained without any collateral security, it increases the risk assumed by the lender, which leads to an increase in the cost of debt.

What is the Cost of Equity?

Equity shares are the most vital source of raising long-term capital for any company, as a company cannot be formed without equity share capital. Equity shareholders are paid based on the earnings of the company. They are known as 'residual owners' of the company since they receive only what is left after all claims on the company have been settled. Although they enjoy the reward and bear the risk of ownership, their liability is limited to the extent of capital contributed by them to the company. Through their right to vote, the shareholders have a right to participate in the decision-making of the company. This leads to dilution of control in the enterprise.

Cost of equity, in simple terms, is the return that a company must incur in exchange for a given venture. When a corporation decides whether it needs fresh financing, the cost of equity determines the return that the enterprise must achieve to warrant the new initiative.

The cost of equity may be calculated in two different ways:

  • Calculation of cost of equity using the dividend capitalization method

The dividend capitalization model can be used to calculate the cost of equity only if a company pays dividends. The calculation is based on future dividends. This is because the company's obligation to pay dividends is known as the cost of paying shareholders. This is the cost of equity.

Cost of equity (%) = Dividend per share (for next year)/Current market value of stock + Growth rate of Dividend

  • Cost of equity using the capital asset pricing model:

This method describes the relationship between systematic risk and expected return for assets. The aim of this method is to evaluate whether a stock is valued when its risk, as well as time value of money, are compared with its expected return.

Expected rate of return (%) = Risk-free rate + beta of investment * (market rate of return – the risk-free rate of return)

  • The beta is a measure of risk calculated as a regression on the corporation's stock price. Volatility and beta have a direct relationship. This implies that as the volatility becomes higher, the value of beta also increases.  If a stock is considered riskier than the market, it will have a beta greater than one. If a store has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
  • The risk-free rate is defined as the rate of return paid on risk-free investments.
  • The average market rate of the return on the investment is known as the market rate of return.

Why is the cost of equity more than the cost of debt?

  1. Procurement costs- Equity is raised by a company by inviting the public to subscribe to its shares. This involves high floatation costs like an issue of prospectus, the appointment of underwriters, stockbroker, merchant bankers etc. However, debt involves lower costs as obtaining loans from banks, or public deposits does not involve as many formalities and expenses as there are in the case of the issue of equity.
  2. Maintenance costs- Equity requires dividends to be paid to shareholders at prefixed times during the year. These are not tax-deductible. However, the cost of debt involves the payment of interest, which is tax-deductible.
  3. Dilution of control- The more equity is issued, the more members there are that enjoy voting rights regarding firm decisions. Although this may not have a direct financial impact on the company, a wrong unanimous decision on the part of shareholders may cause future turbulence for the company. Debt does not involve such problems as debt holders do not enjoy any voting rights.

Main Differences Between Cost of Debt and Cost of Equity In Points

  1. Cost of debt is the expenses incurred by a firm in obtaining borrowed funds. It includes both payments of interest and repayment of the initial debt amount. The cost of equity is the required rate of return by equity shareholders, or the equities held by shareholders.
  2. The cost of debt is tax-deductible as interest payment is exempted from tax. The cost of equity is not tax-deductible.
  3. The cost of debt is determined at a rate demanded by debt holders of a company. The cost of equity is determined at a rate favourable to shareholders of the company.
  4. The cost of debt is received by debt holders of the company, while the cost of equity is received by shareholders of the company.
  5. Interest is paid on debt. Interest is not paid on equity.
  6. The dividend is paid on equity. The dividend is not paid on debt.
  7. Debt is generally given against the security of some assets, while equity does not involve any such obligation.
  8. Examples of debt- include public deposits, bonds, issues of debentures etc. Examples of equity-issue of equity shares and preference shares.

Conclusion

Two methods of raising business finance are equity and debt. Debt consists of the issue of debentures, public deposits, bonds etc. Equity includes both equities share capital and preference share capital. This article has attempted to explain the differences between the costs involved with both the sources of finance over various parameters like which cost is higher, methods to calculate the two costs, rate of return, payment of interest or payment of dividend, etc. This article has further explained the concept of cost of equity and its formula. It has also covered the concept of debt and the reasons why the cost of debt is generally cheaper than the cost of equity. The two sources of business finance have their own merits and demerits that need to be carefully analysed before making a choice about the source of finance most suitable for one's enterprise.


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"Difference Between Cost of Debt and Cost of Equity." Diffzy.com, 2022. Sun. 02 Oct. 2022. <https://www.diffzy.com/article/difference-between-cost-of-debt-and-cost-654>.



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