Glossary

17.2 The Costs of Debt and Equity Capital

3 min read•june 18, 2024

The costs of debt and equity capital are crucial components in a company's financial structure. factors in tax benefits, while equity cost estimation methods like CAPM and DGM consider market risk and dividend growth.

Weighted Average (WACC) combines these costs to determine a company's overall capital cost. This metric is essential for evaluating investment opportunities and optimizing the balance between debt and equity financing.

The Costs of Debt and Equity Capital

After-tax cost of debt

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  • Represents the effective cost of debt financing for a company, considering the tax deductibility of interest payments
  • Calculated using the formula: rd(1−t)r_d(1-t)
    • rdr_d denotes the before-tax cost of debt ( on the company's debt)
    • tt represents the company's (tax rate applied to the last dollar of income)
  • Accounts for the fact that interest payments on debt reduce a company's taxable income, thus lowering the effective cost of debt ()
  • Plays a crucial role in determining the overall cost of capital for a company

Return to debt holders vs cost of debt

  • Return to debt holders (before-tax cost of debt) is the yield to maturity (rdr_d) on the company's debt
    • Represents the return required by debt holders to lend money to the company (coupon payments and principal repayment)
  • Cost of debt to the firm () is lower than the return to debt holders due to the tax deductibility of interest payments
    • Calculated as rd(1−t)r_d(1-t), taking into account the company's marginal tax rate (tt)
    • Reflects the effective cost of debt financing for the company after considering tax benefits ()
  • The level of debt in a company's affects its and potential for

Methods for estimating equity cost

  • (CAPM) estimates the cost of equity based on the stock's sensitivity to market risk
    • Formula: re=rf+βe(rm−rf)r_e = r_f + \beta_e(r_m - r_f)
      • rer_e represents the cost of equity
      • rfr_f denotes the (yield on government bonds)
      • βe\beta_e is the stock's , measuring its systematic risk relative to the market
      • rmr_m represents the expected return on the
    • Accounts for the stock's exposure to non-diversifiable market risk and the risk premium demanded by investors
    • The difference between rmr_m and rfr_f represents the
  • (DGM) estimates the cost of equity based on expected dividend growth
    • Formula: re=D1P0+gr_e = \frac{D_1}{P_0} + g
      • rer_e represents the cost of equity
      • D1D_1 denotes the expected dividend per share in the next period
      • P0P_0 is the current stock price
      • gg represents the expected (assumed to be constant)
    • Assumes that the stock's value is the present value of all future dividends, growing at a constant rate
    • Suitable for companies with stable dividend growth and a long history of paying dividends (mature companies)

Weighted Average Cost of Capital (WACC)

  • Represents the overall cost of capital for a company, considering both debt and equity financing
  • Calculated by weighting the costs of debt and equity based on their proportions in the company's
  • Used to evaluate investment opportunities and determine the minimum required return for new projects
  • Reflects the company's optimal mix of debt and equity financing to minimize its cost of capital

Key Terms to Review (23)

After-tax cost of debt: After-tax cost of debt is the net cost a company incurs on its debt after accounting for tax deductions. It is an important measure as interest expenses are tax-deductible, reducing the overall expense of borrowing.
After-Tax Cost of Debt: The after-tax cost of debt represents the effective cost of borrowing money for a company, taking into account the tax benefits associated with debt financing. It is a crucial consideration in determining a firm's weighted average cost of capital (WACC).
Beta: Beta measures the volatility or systematic risk of a security or portfolio relative to the overall market. A beta greater than 1 indicates more volatility than the market, while a beta less than 1 indicates less volatility.
Beta: Beta is a measure of the volatility or systematic risk of a financial asset or portfolio in relation to the overall market. It represents the sensitivity of an asset's returns to changes in the market's returns, providing a quantitative assessment of an investment's risk profile.
Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It provides a framework for understanding how the market values an asset based on its systematic risk, which is measured by the asset's beta. CAPM is a fundamental concept in finance that is widely used in investment analysis, portfolio management, and corporate finance decision-making.
Capital structure: Capital structure is the mix of debt and equity that a firm uses to finance its operations and growth. It directly impacts the company's risk, cost of capital, and overall financial strategy.
Capital Structure: Capital structure refers to the mix of debt and equity financing that a company uses to fund its operations and investments. It represents the relative proportions of different sources of capital, such as short-term debt, long-term debt, and equity, that a company employs to finance its assets and activities. The capital structure of a company is a crucial aspect of corporate finance, as it directly impacts the company's financial risk, cost of capital, and ultimately, its overall value and performance.
Cost of Capital: The cost of capital refers to the required rate of return that a company must earn on its investments to maintain the value of its stock and attract capital from investors. It represents the minimum acceptable rate of return for a company's investment projects, taking into account the risks associated with the company's capital structure and the opportunity cost of the funds invested.
Dividend Growth Model: The Dividend Growth Model is a valuation method used to determine the intrinsic value of a stock by estimating the present value of its future dividend payments. It assumes that a company's dividends will grow at a constant rate, allowing investors to forecast the company's future dividends and discount them back to the present to arrive at the stock's current worth.
Dividend Growth Rate: The dividend growth rate refers to the rate at which a company's dividend payments increase over time. It is an important consideration for investors evaluating the potential returns from a stock investment, as a higher dividend growth rate can lead to greater long-term income and capital appreciation.
Equity Risk Premium: The equity risk premium is the additional return that investors expect to receive for holding riskier equity investments compared to the return from risk-free assets. It represents the compensation for taking on the higher level of risk associated with investing in the stock market rather than safer investments like government bonds.
Financial distress: Financial distress occurs when a firm struggles to meet its financial obligations, leading to potential insolvency or bankruptcy. It often results in increased borrowing costs and operational disruptions.
Financial Distress: Financial distress refers to a situation where a company or individual is struggling to meet their financial obligations and is at risk of defaulting on debt payments or even bankruptcy. It is a critical concept in the context of capital structure, the costs of debt and equity capital, capital structure choices, and optimal capital structure.
Financial leverage: Financial leverage is the use of borrowed funds to increase the potential return on investment. It involves amplifying both potential gains and potential losses by using debt financing.
Interest tax shield: The interest tax shield is the reduction in taxable income that results from claiming interest payments as a tax-deductible expense. This benefit lowers the overall cost of debt for firms and can influence their capital structure decisions.
Interest Tax Shield: The interest tax shield refers to the reduction in a company's tax liability due to the deductibility of interest expenses on debt financing. This concept is particularly relevant in the context of analyzing the costs of debt and equity capital, as well as making capital structure choices.
Leverage: Leverage refers to the use of debt or other financial instruments to increase the potential return on an investment. It involves using borrowed funds or financial derivatives to magnify the impact of market movements, allowing investors to potentially generate higher returns but also exposing them to greater risk.
Marginal Tax Rate: The marginal tax rate is the tax rate applied to the next dollar of taxable income. It represents the additional amount of tax owed on each additional unit of income earned, and it is a crucial concept in understanding the costs of debt and equity capital as well as the calculation of the weighted average cost of capital.
Market Portfolio: The market portfolio is a theoretical portfolio that represents all the investable assets in the market, weighted by their market capitalization. It is a key concept in the Capital Asset Pricing Model (CAPM) and the evaluation of the costs of debt and equity capital.
Risk-free rate: The risk-free rate is the theoretical return on an investment with zero risk of financial loss. It typically represents the interest rate on short-term government securities, like U.S. Treasury bills, considered free from default risk.
Risk-Free Rate: The risk-free rate is the theoretical rate of return of an investment with zero risk. It represents the interest rate on an asset considered to have no default risk, such as U.S. Treasury bills. This rate is a critical component in various financial models and concepts, including the Discounted Cash Flow (DCF) Model, the Capital Asset Pricing Model (CAPM), the costs of debt and equity capital, and the Weighted Average Cost of Capital (WACC).
Yield to Maturity: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that makes the present value of all future coupon payments and the bond's par value at maturity equal to the bond's current market price. YTM is a key concept in understanding the time value of money, bond characteristics, bond valuation, interest rate risks, and the cost of capital.
Yield to maturity (YTM): Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is expressed as an annual percentage rate and takes into account the bond's current market price, par value, coupon interest rate, and time to maturity.
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