Investors' Minimum Required Rates of Return, Cost of Debt and Cost of Equity

A company may raise capital by issuing

• debt or 
• equity, 

Both of which have associated costs.



Investors' Minimum Required Rates of Return

Investors' minimum required rates of return refer to the return they require for providing funds to the company.



Cost of Debts

A company's cost of debt is easy to estimate as it is reflected in the interest payments that the company is contractually obligated to make to debt holders.

For investors who provide debt capital to the company, their minimum required rate of return is the periodic interest rate they charge the company for using their funds.

All providers of debt capital receive the same interest rate.

Therefore, the company's cost of debt and investor's minimum required rate of return on debt are the same.



Cost of Equity

Estimating cost of equity is difficult because the company is not contractually obligated to make any payments to common shareholders.

For investors who provide equity capital tot he company, the future cash flows that they expect to receive are uncertain (in both timing and amount), so their minimum required rate of return must be estimated.

Further, each investor may have different expectations regarding future cash flows.

Therefore, the company's cost of equity may be different from investors' minimum required rate of return on equity.





Additional notes:

The company's cost of equity can be estimated using the dividend discount model (DDM) and capital asset pricing model (CAPM).

The costs of debt and equity are used to estimate a company's weighted average cost of capital (WACC), which represents the minimum required rate of return that the company must earn on its investments.