In this case, the "cost" being referred to is the measurable cost of obtaining capital. With debt, this is the interest expense a company pays on its debt. With equity, the cost of capital refers to the claim on earnings which must be afforded to shareholders for their ownership stake in the business.

For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for $40,000.

Suppose your business earns $20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.

Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000).

From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).

Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage, as it presents a fixed expense, thus increasing a company's risk. Going back to our example, suppose your company only earned $5,000 during the next year. With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000). With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% x $5,000).

So, as you can see, provided a company is expected to perform well, debt financing can usually be obtained at a lower effective cost. However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.

Companies are never 100% certain what their earnings will amount to in the future (although they can make reasonable estimates), and the more uncertain their future earnings, the more risk presented. Thus, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations. New businesses with high uncertainty may have a difficult time obtaining debt financing, and thus finance their operations largely through equity.

(For more on the costs of capital, see Investors Need A Good WACC.)

  1. What does a buyback signify about a given company's financial health?

    The most common interpretation of a stock buyback is that the issuing company is thriving financially. Buybacks are often ... Read Full Answer >>
  2. Which is more important when estimating cost of capital - debt or equity?

    Determining optimal capital structure means identifying the right mix of debt and equity capital that provides needed funds ... Read Full Answer >>
  3. What are the different ways that corporations can raise capital?

    There are two types of capital that a company can use to fund operations: debt and equity. Prudent corporate finance practice ... Read Full Answer >>
  4. How do interest rates influence a corporation's capital structure?

    Interest rates primarily influence a corporation's capital structure by affecting the cost of debt capital. Companies finance ... Read Full Answer >>
  5. Do you discount working capital in net present value (NPV)?

    Net present value (NPV) calculations should include the discounted value of changes in working capital. This treatment of ... Read Full Answer >>
  6. How is working capital different from fixed capital?

    There are several key differences between working capital and fixed capital. Most importantly, these two forms of capital ... Read Full Answer >>
Related Articles
  1. Economics

    What Happens in a Make-or-Buy Decision?

    A make-or-buy decision happens when a company must choose to either manufacture an item itself, or buy it premade from a supplier.
  2. Technical Indicators

    Key Financial Ratios to Analyze Investment Banks

    Find out which financial ratios are most useful when analyzing an investment bank, and why tracking capital efficiency is especially important.
  3. Fundamental Analysis

    Understanding the Internal Rate of Return Rule

    The internal rate of return rule is a popular method used to compare investments or projects.
  4. Term

    How Equity Capital Markets Work

    An equity capital market is a market existing between companies and financial institutions that raises money for the companies.
  5. Economics

    How to Do a Cost-Benefit Analysis

    The benefits of a given situation or business-related action are summed and then the costs associated with taking that action are subtracted.
  6. Economics

    Modified Internal Rate of Return (MIRR)

    Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
  7. Fundamental Analysis

    Understanding the Capital Adequacy Ratio

    The capital adequacy ratio (CAR) is an international standard that measures a bank’s risk of insolvency from excessive losses. Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable ...
  8. Investing

    Additional Paid-In Capital

    Additional paid-in capital is an account in the equity section of a balance sheet. It represents the additional amount paid for the company’s shares over the par value of the shares. Additional ...
  9. Fundamental Analysis

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  10. Investing

    Return On Capital Employed - ROCE

    Return on Capital Employed (ROCE) is a financial ratio that measures company's ability to earn a return on all of the capital it employs.
  1. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  2. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present ...
  3. Cost Test

    A standard test applied to a process to determine if the net ...
  4. Asset Condition Assessment

    A report outlining how an organization can manage capital assets ...
  5. Capital Expenditure (CAPEX)

    Capital expenditure, or CapEx, are funds used by a company to ...
  6. Working Capital

    Working capital is a measure of both a company's efficiency and ...

You May Also Like

Hot Definitions
  1. Cyber Monday

    An expression used in online retailing to describe the Monday following U.S. Thanksgiving weekend. Cyber Monday is generally ...
  2. Bar Chart

    A style of chart used by some technical analysts, on which, as illustrated below, the top of the vertical line indicates ...
  3. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  4. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  5. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  6. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
Trading Center