Difference Between Cost of Equity and Cost of Debt

Key Difference – Cost of Equity vs Cost of Debt
 

Cost of equity and cost of debt are the two main components of cost of capital (Opportunity cost of making an investment). Companies can acquire capital in the form of equity or debt, where the majority is keen on a combination of both. If the business is fully funded by equity, cost of capital is the rate of return that should be provided for the investment of shareholders. This is known as cost of equity. Since there is usually a portion of capital funded by debt as well, cost of debt should be provided for debt holders. Thus, the key difference between cost of equity and cost of debt is that cost of equity is provided for shareholders whereas cost of debt is provided for debt holders.

CONTENTS
1. Overview and Key Difference
2. What is Cost of Equity
3. What is Cost of Debt
4. Side by Side Comparison – Cost of Equity vs Cost of Debt
5. Summary

What is Cost of Equity

Cost of Equity is the required rate of return by the equity shareholders. Cost of equity can be calculated using different models; one of the most commonly used one being the Capital Assets Pricing Model (CAPM). This model investigates the relationship between systematic risk and expected return for assets, particularly shares. Cost of Equity can be calculated using CAPM as follows.

r_a= r_f+ β_a (r_m – r_f)

Risk Free Rate= (r_f)

Risk free rate is the theoretical rate of return of an investment with zero risk. However practically there is no such investment where there is absolutely no risk. The government Treasury bill rate is usually used as an approximation to the risk free rate due to its low possibility of default.

Beta of the Security= (β_a)

This measures how much a company’s share price reacts against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is more than one, the share is exaggerating the market’s movements; less than one means the share is more stable.

Equity Market Risk Premium= (r_{m –} r_f)

This is the return that investors expect to be compensated for investing above the risk free rate. Thus, this is the difference between market return and risk free rate.

E.g. ABC Ltd. wants to raise $1.5 million and decides to raise this amount entirely from equity. Risk-free rate = 4%, β = 1.1 and Market rate is 6%.

Cost of Equity = 4% + 1.1 * 6% = 10.6%

Equity capital does not need to pay interest; thus, the funds can be successfully utilized in the business without any additional cost. However, equity shareholders generally expect a higher rate of return; therefore, the cost of equity is higher than cost of debt.

What is Cost of Debt

Cost of debt is simply the interest a company pays on its borrowings. Cost of debt is tax deductible; thus, this is usually expressed as an after tax rate. Cost of debt is calculated as below.

Cost of Debt = r (D)*(1 – t)

Pre-tax Rate = r (D)

This is the original rate at which the debt is issued; thus, this is the pre-tax cost of debt.

Tax Adjustment = (1 – t)

The rate at which tax payable should be deducted by 1 to arrive at the post-tax rate.

E.g. XYZ Ltd. issues a bond of $ 50,000 at the rate of 5%. Company tax rate is 30%

Cost of Debt = 5% (1 – 30%) = 3.5%

Tax savings can be made on debt while equity is tax payable. Interest rates payable on debt is generally lower compared to the returns expected by equity shareholders.

Figure 1: Interest is payable on debt

Weighted Average Cost of Capital (WACC)

WACC calculates an average cost of capital considering the weightages of both equity and debt components. This is the minimum rate that should be achieved in order to create shareholder value. Since most companies comprise of both equity and debt in their financial structures, they have to consider both in determining the rate of return that should be generated for the capital holders.

The composition of debt and equity is also vital for a company and should be at an acceptable level at all times. There is no specification of an ideal ratio as to how much debt and how much equity a company should have. In certain industries, especially in capital intensive ones, a higher proportion of debt is deemed to be normal. The following two ratios can be calculated to find the mixture of debt and equity in capital.

Debt Ratio = Total debt / Total assets *100

Debt to Equity Ratio = Total debt/Total equity *100

What is the difference between Cost of Equity and Cost of Debt?

Summary – Cost of Debt vs Cost of Equity

The principle difference between cost of equity and cost of debt can be attributed to whom the returns should be paid. If it is for the shareholders, then cost of equity should be considered and if it is to the debt holders, then cost of debt should be calculated. Even though tax savings are available on debt, a high portion of debt in the capital structure is not regarded as a healthy sign.

Reference:
1. “Cost Of Equity – Complete Guide To Corporate Finance.” Investopedia. N.p., 03 June 2014. Web. 20 Feb. 2017.
2. “Cost Of Debt.” Investopedia. N.p., 30 Dec. 2015. Web. 20 Feb. 2017.
3. “Weighted Average Cost of Capital.” Weighted Average Cost of Capital (WACC) | Formula | Example. N.p., n.d. Web. 20 Feb. 2017.
4. “Debt vs. Equity — Advantages and Disadvantages.” Findlaw. N.p., n.d. Web. 20 Feb. 2017.

Image Courtesy:
1. “Greece gmnt bonds”By Verbal.noun at English Wikipedia (CC BY 3.0) via Commons Wikimedia

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