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The most expensive way is by issuing equity. This might throw them off guard, but depending on the person they might love the answer. With cost of capital for corporate debt at record low levels, its the cheapest solution. Shareholders usually have a higher cost of capital because they expect a chunk of the profit. Obviously there are other instruments such as mezz and things like that, but I think equity is a better answer.
Cost of debt doesn't really have anything to do with P/E ratios. A high P/E ratio implies that investors are expecting strong growth going forward, but it doesn't mean that they aren't demanding much. Honestly, its more like the opposite, if the company doesn't execute on its growth targets, the stock will get hammered since the implied growth in the valuation was high.
Expected returns are a function of risk. Debt is given pre-negotiated payments and is paid out before equity in the case of default, so it is inherently less risky than equity. If the cost of debt was higher than the cost of equity, no one would ever invest in the equity of that company. Thus you can never have a cost of debt higher than cost of equity.
This only takes into account default risk. You still have to consider interest rate risk, fx risk, etc.
yes. i would go with subdebt.
Hi ct52,
Can you please explain what you mean by no one would ever invest in the equity of the company, if the cost of debt was to be higher than the cost of equity? Thanks.
Easiest way to explain it. Debt carries less risk than equity due to its seniority in the capital structure. Think about it like this. If a business has debt on it and for some reason it goes bankrupt, the creditors always come first. Creditors hold liens on the assets so they have a chance of recovering something. Equity holders will get the short end of the stick. Since equity holders are at the bottom of the structure, they get the highest return through cash flow and appreciation. The best way to think about it is as a measure of risk. Debt is cheaper than equity because its carries lower risk.
TeddyTheBear,
With regards to the different payment methods that can be used in accretion/dilution models, how would you calculate the cost of debt, cost of stock and the yield of the seller?
According to the BIWS guide that I'm using, it says that to calculate the two, you use:
"Cost of Debt = Interest Rate on Debt * (1 – Buyer Tax Rate)
Cost of Stock = Reciprocal of the Buyer’s P / E multiple, i.e. E / P or Net Income / Equity Value
Yield of Seller = Reciprocal of the Seller’s P / E multiple (ideally, the P /E multiple at the purchase price for the deal)"
This is a little confusing to me. Would you recommend using something like CAPM to calculate the cost of stock, rather than the reciprocal of the buyer's P/E multiple?
CAPM would be the appropriate method to calculate cost of equity. However, if you use the reciprocal of P/E, that is just a good proxy to "estimate" the cost of equity (e.g. if you would wanna quickly look at the cheapest or most expensive form of financing). Correct me if I'm wrong here guys. Thanks.
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