How Do Cost of Debt Capital and Cost of Equity Differ?

Every business needs capital to operate successfully. Capital is the money a business—whether it's a small business or a large corporation—needs and uses to run its day-to-day operations. Capital may be used to make investments, conduct marketing and research, and pay off debt.

There are two main sources of capital companies rely on—debt and equity. Both provide the necessary funding needed to keep a business afloat, but there are major differences between the two. And while both types of financing have their benefits, each also comes with a cost.

Below, we outline debt and equity capital, and how they differ.

Key Takeaways

  • Debt and equity capital both provide businesses money they need to maintain their day-to-day operations.
  • Companies borrow debt capital in the form of short- and long-term loans and repay them with interest.
  • Equity capital, which does not require repayment, is raised by issuing common and preferred stock, and through retained earnings.
  • Most business owners prefer debt capital because it doesn't dilute ownership.

Debt Capital

Debt capital refers to borrowed funds that must be repaid at a later date. This is any form of growth capital a company raises by taking out loans. These loans may be long-term or short-term such as overdraft protection.

Debt capital does not dilute the company owner's interest in the firm. But it can be cumbersome to pay back interest until its loans are paid off—especially when interest rates are rising.

Companies are legally required to pay out interest on debt capital in full before they issue any dividends to shareholders. This makes debt capital higher on a company's list of priorities over annual returns.

While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require interest payments in return. This interest rate is the cost of debt capital. Debt capital can also be difficult to obtain or may require collateral, especially for businesses that are in trouble.

If a company takes out a $100,000 loan with a 7% interest rate, the cost of capital for the loan is 7%. Because payments on debts are often tax-deductible, businesses account for the corporate tax rate when calculating the real cost of debt capital by multiplying the interest rate by the inverse of the corporate tax rate. Assuming the corporate tax rate is 30%, the loan in the above example then has a cost of capital of 0.07 X (1 - 0.3) or 4.9%.

Equity Capital

Because equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. Equity funds don't require a business to take out debt which means it doesn't need to be repaid. But there is some degree of return on investment shareholders can reasonably expect based on market performance in general and the volatility of the stock in question.

Companies must be able to produce returns—healthy stock valuations and dividends—that meet or exceed this level to retain shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate, the risk premium of the wider market, and the beta value of the company's stock to determine the expected rate of return or cost of equity.

Equity capital reflects ownership while debt capital reflects an obligation.

Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.

Equity capital may come in the following forms:

  • Common Stock: Companies sell common stock to shareholders to raise cash. Common shareholders can vote on certain company matters.
  • Preferred Stock: This type of stock gives shareholders no voting rights, but does grant ownership in the company. These shareholders do get paid before common stockholders in case the business is liquidated.
  • Retained Earnings: These are profits the company has retained over the course of the business' history that has not been paid back to shareholders as dividends.

Equity capital is reported on the stockholder's equity section of a company's balance sheet. In the case of a sole proprietorship, it shows up on the owner's equity section.