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Cost of Debt and Equity


Business obtains funds in the form of debt or ownerˇ¦s equity.  In both cases, the creditors or the owners are investing money to finance the firmˇ¦s projects.  It is assumed that a new fund is required in order to compare the costs incurred for the given company.

The cost of debt is the stated rate of interest, which is equal to the required rate of return from investors when the firm borrows money.  The borrowing can be issuing bonds to investors or promissory notes to bank.  The cost of equity is the required rate of return on funds from new preferred or common stockholders.  Both cases incur flotation costs.  Flotation cost includes investment bankersˇ¦ fees and commissions, and attorneysˇ¦ fees (Gallagher and Andrew, 2002).  However, the flotation cost for the debt is small and usually ignored; while the flotation cost for issuing preferred or common stock is significant and must be deducted from the prices paid by investors.

Ignoring taxes, the investors expected rate of return would be similar whether the new fund is in the form of debt or equity.  But taking the flotation cost into consideration, the cost of debt is lower than the cost of equity for the given company. 


References

Gallagher, Timothy J and Andrew, Joseph D Jr (2002), Financial Management: Principles and Practice, 2nd Edition, Prentice Hall, Upper Saddle River, New Jersey


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