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.
FAQs
The Cost of Equity is generally higher than the Cost of Debt since equity investors take on more risk when purchasing a company's stock as opposed to a company's bond.
How do cost of debt capital and cost of equity differ? ›
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.
What is the difference between debt capital and equity capital? ›
Debt Capital is the borrowing of funds from individuals and organisations for a fixed tenure. Equity capital is the funds raised by the company in exchange for ownership rights for the investors. Debt Capital is a liability for the company that they have to pay back within a fixed tenure.
How do debt and equity differ in their cost and risk involved? ›
The cost of equity is more than the cost of debt and it is a risky form of investment as the shareholders will only get returns if the company makes a profit, but in the case of debt, the lenders need to be paid a fixed rate of interest for loans.
What is difference between capital and equity? ›
Equity represents the total amount of money a business owner or shareholder would receive if they liquidated all their assets and paid off the company's debt. Capital refers only to a company's financial assets that are available to spend.
What is the relationship between the cost of capital and the debt to equity ratio? ›
The ratio between debt and equity in the cost of capital calculation should be the same as the ratio between a company's total debt financing and its total equity financing. Put another way, the cost of capital should correctly balance the cost of debt and cost of equity.
What is cost of equity in simple words? ›
“Cost of equity” refers to the rate of return expected on an investment funded through equity. Investors and business owners use the metric to determine if a project or business investment is worthwhile.
What is the difference between equity debt and debt? ›
"Debt" involves borrowing money to be repaid, plus interest, while "equity" involves raising money by selling interests in the company. Essentially you will have to decide whether you want to pay back a loan or give shareholders stock in your company.
What is the difference between equity capital and debt capital quizlet? ›
Debt financing raises funds by borrowing. Equity financing raises funds from within the firm through investment of retained earnings, sale of stock to investors, or sale of part ownership to venture capitalists.
Why cost of equity capital is more than cost of debt? ›
Therefore, the Cost of Equity Share Capital is more than the cost of Debt because Equity shares have high risk than debts.
Cost of Debt vs Cost of Equity: Which Is Cheaper? Debt is typically cheaper than equity due to tax-deductibility of interest and lower risk premiums. However, as debt levels rise, the cost of debt also increases to compensate lenders for higher default risk.
Why cost of debt is cheaper than cost of equity? ›
Debt is also cheaper than equity from a company's perspective is because of the different corporate tax treatment of interest and dividends. In the profit and loss account, interest is subtracted before the tax is calculated; thus, companies get tax relief on interest.
What is the cost of debt capital? ›
The cost of debt is the effective rate that a company pays on its debt, such as bonds and loans. Debt is one part of a company's capital structure, with the other being equity. Calculating the cost of debt involves finding the average interest paid on all of a company's debts.
What is cost of equity with example? ›
For example, let's consider a well-established retail corporation with a beta of 1.2. If the risk-free rate is 3% and the market's expected return is 8%, the equity risk premium would be 8% – 3% = 5%. The company's equity cost calculation will be 3% + (1.2 * 5%) = 9%.
Can the cost of equity be negative? ›
Current Equity Value cannot be negative, in theory, because it equals Share Price * Shares Outstanding, and both of those must be positive (or at least, greater than or equal to 0).
Why is the cost of debt capital is lower than the cost of equity capital? ›
Interest payments on debt are tax deductible, which provides a tax shield for companies. This lowers the effective cost of debt financing. Equity returns in the form of dividends or capital gains do not receive this tax benefit, making the after-tax cost of equity higher.
What is the difference between equity cost of capital and WACC? ›
The cost of equity applies only to equity investments, whereas the Weighted Average Cost of Capital (WACC) accounts for both equity and debt investments. Cost of equity can be used to determine the relative cost of an investment if the firm doesn't possess debt (i.e., the firm only raises money through issuing stock).
Why the cost of equity share capital is greater than the cost of debt? ›
Therefore, the Cost of Equity Share Capital is more than the cost of Debt because Equity shares have high risk than debts.
