Equity is cheaper than debt, isn't it?
Is equity really the most expensive source of funds in a companies capital structure? By looking at historical dividend payouts from Apple, Microsoft etc, it seems as if their dividend yield would always 2%.
How's that more expensive than any debt instrument?
Thanks for a hearty chuckle.
It's not really fair to look at the dividend yield from some of the largest companies in the world as the cost of equity. Keep studying.
*duplicate comment
The total ROI on Equity should be higher than the cost of debt. That is positive leverage. If you don’t have that, then why not be a lender and why bother with your equity investment?
Cost of equity reflects the risk of the company relative to the market in excess of the risk-free rate. It has nothing to do with the distribution of capital. Remember when you release a dividend the stock price should equal the total distribution of that dividend.
Debt should be cheaper than equity because it takes on less risk.
But if its stated that the risk of an equity investment is higher and therefore equity investors need to be compensated with a higher return than debt investors then how are they eventually? What do you mean by "the stock price should be equal to that dividend"?
Equity owners don't only achieve returns through dividends. They also benefit through appreciation in the value of their stock.
If the companies market cap is 100m and they pay a 20m dividend then the new market cap should converge to 80m
You should compare the total returns of an equity investment (i.e. Dividends + Capital Gains) with the costs of debt.
Ding ding ding
if you watch shark tank (which you should) you would have learned that for a startup, equity is more expensive than debt for the founder to sell IF THE COMPANY WILL GROW EXPONENTIALLY.
So, imagine your small company had 100k in sales (revenue) on 20k in costs, for a total profit of 80k. Imagine that you could scale that business to 1 billion in sales, at the same cost ratio, so 200mm in costs, for a total profit of 800mm.
Imagine you need 1 million dollars to get the scale going, and you as the founder/owner have 2 choices 1 - give up 40% of the equity for that 1mm 2 - borrow 1mm for 20% annual interest, repayable within 5 years
If you can scale up to 10mm in sales within 1 year, thus profiting 8mm minus your debt...and then keep up scaling....the total vale of your equity will be higher, than if you gave up 40% of your equity for that 1mm equity stake
Do the math
under the equity sale, and our 10mm revenue projection 40% of 8mm = 3.2mm (this is given to your new shark investor) leaving you 4.8mm
or 20% interest on 1mm = 200k, after which you buy back/retire that debt (so, your 8mm profit becomes 6.8mm, (and you are now debt free)
which scenario do you choose?
Who hurt you?
many many people
no one is saying anything about the tax deductability of debt?
Why add further to the confusion. We're dealing with an OP that doesn't get why debt is cheaper than equity. We don't need any heads exploding.
hahaha but isn't this the fundamental argument for debt > equity (cheaper)?
you dont need to yes tax reduces its cost by being tax deductable but from a risk reward standpoint a priori debt is always cheaper than equity
You need to also look at the value that is transferred when the shares are sold in a buyout situation (i.e. capital gains). Lets say someone buys out Apple for X in 10years. If you calculate all the dividends + the amount you need to pay the shareholders for 1B of shares issued it should be more than what you would payout for issuing 1B of debt.
Grants are cheaper
accountant here...debt is cheaper because of the corporate tax shield and it's also less risky (generally)
Placeat quo iste debitis fugiat velit. Aut ea ipsam ut. Tempora rerum omnis et quas ut doloremque. Et aspernatur aliquid quis possimus id. Quo consequatur autem laboriosam inventore sit.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...