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The cost of equity is higher relative to the one of debt, because when selling equity you are effectively offering a share of your future performance. And this may amount to much more than the simple interest rate a creditor will charge you. Thus successful company ventures are often financed with debt (when available) so profits remain in the company.
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Is cost of equity capital less than cost of debt capital?
Cost of equity > Cost of debt Reason: When u issue debt, for example in the form of bonds, u have to pay bondholders interest. This interest is tax deductible. On the other hand, when u issue equity, i.e. stocks, u pay dividends. This dividend is taxed as corporate income. Because of the ability of debt to escape taxation vis-a-vis equity, cost of debt is lower than cost of equity. In fact, this is called a debt tax shield.
Is pretax cost of equity higher or lower than after tax cost of equity?
they are equal
Why does the weighted average cost of capital of firms that uses more debt capital lower that that of a firm that uses less debt capital?
Because the cost of debt is generally lower than the cost of equity. This is because in case of financial distress, debt-holders are repaid before the equity holders are, as well as because debt has the assets of the firm as collateral and equity does not.
When a firm initially substitutes debt for equity financing what happens to the cost of capital and why?
According to the balance sheet and the optimal capital structure and the current balance sheet, when an organization makes substitutes the company's equity for financing all of the cost for the capital is prone to decrease particularly when the company's cost of their debt appears to be lower with the cost of the company's equity.
Why should we expect the flotation costs for debt to be significantly lower than those for equity?
Flotation costs for debt are typically lower than those for equity because debt is considered less risky for investors. Lenders have a higher likelihood of being repaid, so they require lower fees and costs compared to equity investors who take on more risk and expect higher returns.
Why don't financial managers use as little debt as possible to keep the cost of equity down?
The answer to the question depends on the motivations of management. Increasing debt increases risk should the economy weaken and repayment becomes a problem. Managers who are owners often prefer to minimize debt regardless of its cost so as to preserve a margin of safety in case hard times comes. If the manager is not an owner, debt is attractive because it provides leverage. Suppose a company without debt earns $100,000 on equity of $1 million. Its return on equity is 10%. Now suppose the manager could borrow another $1 million. If he paid 5% interest, he would net $50,000 additional earnings. Note that the resulting $150,000 of earnings would be a 15% return on the $1 million of equity. Investors would bid up the price of the stock based on the higher return on equity. The Cost of Debt: when a company borrows funds from a financial institution, the interest amount paid on that debt is called cost of debt. Cost of Equity: When a company raises money from shareholders by issuing more shares to them or shares to new shareholders, then the dividend (interest) paid to them is called cost of equity. The use of debt lowers the cost of capital not the cost of equity. Debt holders are paid back before equity holders, therefore there is a decreased risk for debt. Because of the ability of debt to escape taxation vs equity, cost of debt is lower than cost of equity. With all that said; Debt costs less than equity financing, because it is tax deductable vs dividends, that are not tax deductable. Debt to a bank though is more risky from a company's perspective because of liquidation risk vs stock value risk. Maximizing shareholder value is the goal of a company, but risking losing the company and one's job, to the bank and liquidation vs a decrease in stock value, is usually preferable. But, one of the main reasons that financial managers don't use as little debt as possible is because using it allows companies to do projects that they otherwise might be able to afford.
The cost of external equity is greater than the cost of retained earnings because a. floatation costs on new equity b. capital gains tax on new equity c. interest expense d. risk premium?
The cost of external equity is higher because the floatation costs on new equity.
Is debt to equity ration generally equal or less than the debt to asset ratio?
less
Which one is greater debt or equity?
There is not a real answer to this question. It can be either. Debt and equity sum to the total assets. Either one could be more than the other.
Is underwriting spread for debt is generally less than that for equity?
yes
What portion of the WACC calculation is impacted by taxes?
The cost of debt is affected by taxes. The debt portion of the WACC is calculated as (total debt / total invested capital)*expected return on debt*(1 - tax rate). More info: http://en.wikipedia.org/wiki/WACC
Is it better to pay off a mortgage or a home equity loan?
It is generally better to pay off a home equity loan first because it typically has a higher interest rate than a mortgage. By paying off the higher interest debt first, you can save money in the long run.
