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.
- 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).
- 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.
- 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.
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