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Bob asks Victoria to explain the concept of cost of capital. She says that when a business manager or
prospective buyer of a firm is raising capital, debt capital is less expensive than equity capital. Debt
capital is monies borrowed from lenders, such as banks, to fund a business. The lender expects a
return on its investment in the form of interest. In financial terms, interest expense on debt is called the
firm‟s cost of debt. Therefore, a firm pays interest—or a cost of debt—that is based on lending rates in
the capital markets. Acme‟s current cost of debt is 9% per year. However, since Acme can take a tax
deduction for its interest expense, its after-tax cost of debt capital is 5.4% based on a 9% borrowing
rate less 40% of that amount in reduced taxes: 5.4% = 9% × (1 - 40%). So, for every $100 Acme pays
in interest expense to the bank, its income tax obligation is lowered by $40 because interest is a
business expense that lowers the firm‟s taxable income. Thus, in this example, Acme‟s after-tax
interest expense is $60 ($100 paid to the bank minus $40 in reduced taxes).
In order for a firm to raise equity capital by selling stock to investors, it needs to offer an incentive:
the hope of earning a fair reward for making an investment. For stocks, those rewards come in the
form of dividends or capital gains, or both. Collectively, these rewards are an investor‟s return on
investment. As previously discussed, stocks of large U.S. public companies have created average
historical returns of 10% to 12% per year over the long run. Small public company stocks in the
United States have had average historical annual returns of 15% to 20% over the long run. Since
private firms are usually riskier than most small public companies, private firms must offer a rate of
return to their shareholders higher than the returns of less risky stocks of small public firms.
When raising capital by a stock offering, investors can get a higher rate of return if the stock price is
lower. In other words, a lower stock price results in a lower investment for the person buying the
shares. Holding the expected future returns to investors constant, their return on investment is higher
when buying the shares at a low price and, conversely, their return on investment is lower if they pay a
high price for the shares.
Let‟s say that a private firm is raising capital by selling stock. The returns a firm gives its
stockholders are called the firm‟s cost of equity. In other words, to raise new equity capital, the firm
needs to work to reward those new investors. Those rewards are the firm‟s cost of equity.
Furthermore, a firm has both a cost of debt capital and a cost of equity capital, and these two costs
differ. Combined, these costs are called a firm‟s cost of capital. The cost of debt is less than the cost of
equity. Lenders demand a lower rate of return than investors because lenders are in a less risky
position since they normally get paid before investors. Moreover, a firm‟s managers can maximize the
returns to its shareholders by using a blend of debt financing (less expensive) and equity capital (more
expensive). When managers get capital from lenders, the firm does not issue as much stock and,
therefore, the firm‟s profits are divided among fewer shares. Say that a prospective buyer of a firm
must raise $10 million to acquire a target company. If it raised the entire $10 million from the sale of
stock, it would need to offer those shareholders a rate of return of, say, 20% per year on average.
Alternatively, it could raise a portion of the $10 million by borrowing from a bank at, say, an after-tax
interest cost of 5%. In this example, the cost of debt is significantly less than the cost of equity. If the
buyer borrows $5 million from the bank and raises another $5 million through the sale of stock, its
overall cost of capital is much lower than if the full amount was raised from the sale of stock. The
following tables compare the cost of capital in two situations:
Blended Capital Structure of Debt and Equity