Equity is cheaper than debt, isn't it?

Etb's picture
Rank: Senior Monkey | banana points 81

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?

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Comments (22)

Dec 18, 2018

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.

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Dec 18, 2018

*duplicate comment

Dec 18, 2018

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?

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Dec 18, 2018

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.

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Dec 18, 2018

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"?

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Dec 18, 2018

Equity owners don't only achieve returns through dividends. They also benefit through appreciation in the value of their stock.

Dec 18, 2018
Etb:

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"?

If the companies market cap is 100m and they pay a 20m dividend then the new market cap should converge to 80m

Most Helpful
Dec 18, 2018

You should compare the total returns of an equity investment (i.e. Dividends + Capital Gains) with the costs of debt.

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Dec 18, 2018

Ding ding ding

Dec 18, 2018

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?

just google it...you're welcome

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Funniest
Dec 18, 2018

Who hurt you?

Dec 18, 2018

many many people

just google it...you're welcome

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Dec 19, 2018

no one is saying anything about the tax deductability of debt?

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Jan 2, 2019

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.

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Dec 19, 2018

hahaha but isn't this the fundamental argument for debt > equity (cheaper)?

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Dec 18, 2018

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

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Jan 8, 2019

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.

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Jan 9, 2019

Grants are cheaper

Jan 9, 2019

accountant here...debt is cheaper because of the corporate tax shield and it's also less risky (generally)

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Jan 9, 2019

Equity can be more expensive in non-tangible ways. For one, equity holders usually have a say in how a company is operated/managed. Ironically, Apple only pays dividends because investors demanded it. Lenders may impose requirements (i.e. covenants), that are pre-determined, negotiable, and quite frankly loosely enforced sometimes (especially if privately held middle market company).

Debt has limited upside (lenders get paid on time, in full, at stated interest rate, which is best case scenario). Equity literally has unlimited upside-- e.g. stock price goes from $1 to $200 (happened to Apple for real, BTW). Don't let this fool you though, the reverse is equally as possible obviously.

Also, the more shares (i.e. equity) issued by a company, the less to go around to all shareholders (less revenue per share, less earnings per share, less cash-on-hand per share, etc.); a phenomenon known as dilution. This is why companies engage in buying back stock, which has a similar effect as paying dividends. Debt doesn't have this impact, and as others have mentioned, interest payments are tax-deductible, while dividends are not.

Hope this helps.