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.
Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders required rate of return will be the same whether they supply funds by purchasing new shares or by foregoing dividends which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than, the internal equity.
Is Equity Capital Free of Cost?
It is sometimes argued that the equity capital is free of cost. The reasons for such argument is that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to be free of cost. As we have discussed earlier equity capital involves an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of dividends (including capital gains) commensurate with their risk of investment. The market value of the shares determined by the demand and supply forces in a well functioning capital market reflects the return required by ordinary shareholders. Thus the shareholders required rate of return, which equates the present value of the expected dividends with the market value of the share, is the cost of equity capital. The cost of external equity could, however be different from the shareholders required rate of return if the issue price is different from the market price of the share.
Estimating the Cost of Equity Capital
In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors: First, it is very difficult to estimate the expected dividends. Second, the future earnings and dividends are expected to grow over time. Growth in dividends should be estimated and incorporated in the computation of the cost of equity. The estimation of growth is not an easy task. Keeping these difficulties in mind, the methods of computing the cost of internal and external equity are discussed below.
Cost of Internal Equity
The opportunity cost of the retained earnings (internal equity) is the rate of return on dividends foregone by equity shareholders. The shareholders generally expect dividend and capital gain from their investment. The required rate of return of shareholders can be determined from the dividend valuation model.
According to dividend-valuation model, the cost of equity is thus, equal to the expected dividend yield (D/P0) plus capital gain rate as reflected by expected growth in dividends (g).
ke = (D/P0) + g
It may be noted that above equation is based on the following assumptions:
- The market price of the ordinary share (Po) is a function of expected dividends.
- The initial dividend, D is positive (i.e. D > 0).
- The dividends grow at a constant rate g, and the growth rate (g) is equal to the return on equity (ROE) times the retention ratio (b) (i.e. g = ROE x b).
- The dividend payout ratio (i.e. (1 – b)) is constant.
The cost of retained earnings determined by the dividend valuation model implies that if the firm would have distributed earnings to shareholders, they could have invested it in the shares of the firm or in the shares of other firms of similar risk at the market price (Po) to earn a rate of return equal to ke. Thus, the firm should earn a return on retained funds equal to k, to ensure growth of dividends and share price. If a return less than k, is earned on retained earnings, the market price of the firm’s share will fall. It may be re-emphasized that the cost of retained earnings will be equal to the share holders required rate of return.
In addition to its use in constant and variable growth situations, the dividend valuation model can also be used to estimate the cost of equity of no-growth companies. The cost of equity of a share on which a constant amount of dividend is expected perpetually is given as follows:
ke = (D/P0)
Cost of External Equity
The minimum rate of return, which the equity shareholders require, on funds supplied by them by purchasing new shares to prevent a decline in the existing market price of the equity share is the cost of external equity. The firm can induce the existing or potential shareholders to purchase new shares when it promises to earn a rate of return equal to:
ke = (D/P0) + g
Thus, the shareholders required rate of return from retained earnings and external equity is the same. The cost of external equity is, however, greater than the cost of internal equity for one reason. The selling price of the new shares may be less than the market price. In India, the new issues of ordinary shares are generally sold at a price less than the market price prevailing at the time of the announcement of the share issue. Thus, the formula for the cost of new issue of equity capital may be written as follows:
ke = (D/ Io) + g
Where Io is the issue price of new equity. The cost of retained earnings will be less than the cost of new issue of equity if Po> Io.
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- Optimal Capital Structure
- Factors Influencing Dividend Payouts of a Company
- Meaning of Capital Structure
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- Weighted Average Cost of Capital (WACC)
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