An analyst is supposed to figure out the paths which take the firm to the next level, either in terms of profit or in terms of reputation. If we say profit, it means revenue generation. Companies seek investment in terms of equity, not in debt. These two terms are of great understanding.
Cost of Debt vs Cost of Equity
The main difference between the cost of debt and the cost of equity is that the COD is received by the debt holders of a company while COE is provided and received by the shareholders of the company. Both are major components of the cost of capital.
The cost of debt is the amount that is paid by the management against the borrowed resources. The resources, assets which are borrowed from someone else will be taxed, and the amount is meant to be paid by the borrower. It’s tack deducible. Hence it’s usually expressed as a post-tax rate.
The cost of equity means the needed rate of return by equity shareholders. Also, there’s a method to find out the value of the cost of equity. It’s done through models, and the most commonly used one is the Capital assets pricing model (CAPM).
Comparison Table Between Cost of Debt and Cost of Equity
| Parameters of Comparison | Cost of Debt | Cost of Equity |
| Definition | The cost of debt is simply the amount of interest a company pays on its borrowings or the debt held by debt holders of a company. | Cost of equity is the required rate of return by equity shareholders, or we can say the equities held by shareholders. |
| Formula | COD = r(D)* (1-t) where r(D) is the pre-tax rate, (1-t) is tax adjustment. | The formula to calculate cost of equity is r(a) = r(f) + ß(a) [ r(m) – r(f) ] Where r(f) is risk-free rate, ß(a) is beta of the security, r(m) – r(f) is equity market risk premium. |
| Rate on a return basis | Cost of debt is the rate of return expected by the debt holders or bondholders for their investment. | COE is basically a return rate asked from the shareholders of a company. |
| Interest basis | Since the resources or services are borrowed, then interest is meant to be paid. | There’s no paying of interest at any time. |
| Model basis | The cost of debt has nothing to do with models since it’s about taxes. | The cost of equity is calculated through a model proposed, and that is CAPM. |
What is Cost of Debt?
Capital cost is about equity and debt. The cost of debt is about borrowings, taxes on resources, and more. If we see, the cost of debt is the interest rate or an amount of interest which a firm or management pays on its debts.
To calculate the value, a company should know the total sum of interest that is meant to be paid on each debt for the year. Then it divides this number by the total of its debts. The answer you get is the cost of debts.
Observable interest rates play a vital role in analysing the cost of debt.
It’s more targeted towards the calculation of the cost of debt rather than the cost of equity. Not only cost of debt shows the default risk of a firm, but it also reflects the level of interest rates in the market. It’s an integral part of determining a firm’s weighted average cost of capital (WACC).
What is Cost of Equity?
What matters at the end is the returns generated. It’s not only a needful thing but also drives the motivation to the next level. The cost of equity revolves around the generation of revenues as well. It means the returns a company or management required to decide if an investment meets the capital return requirements. In simple terms, it’s the part that is received from the shareholders of a company.
A company’s cost of equity represents the services or something valuable the markets asks in exchange for owning assets and bearing the risk of ownership. There exist various models to calculate the value, but the predominant one is the dividend capitalisation model and the Capital assets pricing model (CAPM).
The formula covers the dividend per share for the next year, the current market value of the stock, and the growth rate of dividends. It’s a reference to two different concepts varying in the party or the lender involved.
There exist two methods through which a company raise capital. Equity mode or the debt mode Equity doesn’t need to be repaid, but it costs more than debt capital due to advantages related to taxes which doesn’t exist here.
Main Differences Between Cost of Debt and Cost of Equity
- The cost of debts accounts for the bondholders or debt holders, while the cost of equity accounts for the shareholders.
- Debt is all about borrowings, banks, and loans, so it’s the amount to be paid while the equity has nothing to do with taxes.
- The cost of debt is the rate asked by bondholders, while the cost of equity is the rate of returns expected by shareholders for their investment.
- Equity doesn’t need to be paid back or repaid, but it’s generally more than the debt. Since the cost of equity is higher than debt, it gives a high rate of returns.
- If we consider the formula, the cost of equity is all about the dividend capitalisation model of the capital asset pricing model, but the cost of debt is all about the pre-tax rates and taxes adjustments.
Conclusion
The cost of capital, according to economic and accounting definition, is the cost of a company’s funds which includes debts and equities. If we consider from an investor point of view, it’s the needed rate of return on a portfolio company‘s existing securities.
Equity focuses on dividends and models, while debts are about taxes and interest rates. The cost of equity is generally more than the cost of debts. Both are equally important in contributing to the company’s profits and revenues.
References
- https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.2010.01611.x
- https://www.jstor.org/stable/248475