The cost of debt is the amount that a company pays to borrow money, typically through issuing bonds or taking out loans. This cost is usually expressed as a percentage, which is based on the interest rate the company pays to its lenders. The cost of debt is important to a company because it affects its ability to invest in new projects or pay dividends to shareholders. A higher cost of debt means that a company has less money available for these purposes, which can limit its growth potential.
The cost of equity, on the other hand, is the return that shareholders expect to earn on their investment in the company. This return is based on the company’s earnings and growth prospects, as well as factors such as market conditions and investor sentiment. The cost of equity is usually higher than the cost of debt because shareholders require a greater return to compensate them for the risks they are taking on by investing in the company. This cost is typically expressed as a percentage, and is used to calculate a company’s weighted average cost of capital (WACC), which is the average cost of all of its sources of financing.
In summary, the cost of debt is the cost of borrowing money, while the cost of equity is the return that investors expect to earn on their investment in the company. Both costs are important to a company’s financial health, and are used to calculate the WACC, which is a key metric used by investors and analysts to evaluate a company’s potential for growth and profitability
The cost of Equity is more expensive than the cost of debt
The cost of equity is generally considered to be more expensive than the cost of debt because equity investors are taking on a higher level of risk than debt holders. Debt holders have a contractual obligation to be repaid with interest, regardless of the company’s financial performance, while equity investors are not guaranteed any return on their investment.
Equity investors are essentially co-owners of the company and share in its profits and losses. As a result, they require a higher rate of return to compensate for the greater level of risk they are taking on. They may also demand higher returns to account for the fact that their investment is typically more long-term than debt financing, and that they have less protection in the event of bankruptcy.
In addition, equity financing typically involves higher transaction costs, such as underwriting fees and legal expenses, than debt financing. This also contributes to the higher cost of equity.
Overall, the higher cost of equity reflects the greater risk and uncertainty involved in investing in the stock market compared to lending money through debt financing. While debt financing can provide a company with more stable and predictable cash flows, equity financing offers the potential for greater returns but also carries higher risks.
About the Author
Dr. Dawkins Brown is the Executive Chairman of Dawgen Global , an integrated multidisciplinary professional service firm .
Dr. Brown earned his Doctor of Philosophy (Ph.D.) in the field of Accounting, Finance and Management
He has over Twenty Six (26) years experience in the field of Audit, Accounting, Taxation, Finance and management . Starting his public accounting career in the audit department of a “big four” firm (Ernst & Young), and gaining experience in local and international audits, Dr. Brown rose quickly through the senior ranks and held the position of Senior consultant prior to establishing Dawgen.
He is a member of Chartered Management Institute (CMI), member of the Institute of Internal Auditors (IIA) , member of the Association of Certified Fraud Examiners (ACFE), member of Information Systems Audit and Control Association ( ISACA ) member of American Planning Association (APA) , member of the American Finance Association (AFA) and member of Association of Certified E-Discovery Specialists (ACEDS).
As Executive Chairman of Dawgen Global , he is responsible for the strategic guidance and strategy execution of several entities within the Dawgen Global Group.
