In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While both types of financing have their benefits, each also carries a cost.

Debt capital refers to funds that are borrowed and must be repaid at a later date. While debt allows a company to leverage a small amount of money into a much greater sum, lenders typically require the payment of interest in return for the privilege. This interest rate is the cost of debt capital. If a company takes out a $100,000 loan with a 7% interest rate, the cost of capital for the loan is 7%. However, 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 * (1 - 0.3), or 4.9%.

Because equity capital typically comes from funds invested by shareholders, the cost of equity capital is slightly more complex. While equity funds need not be repaid, there is a level of return on investment that shareholders can reasonably expect based on the performance of the market in general and the volatility of the stock in question. Companies must be able to produce returns – in the form of healthy stock valuation and dividends – that meet or exceed this level in to retain shareholder investment. The capital asset pricing model (CAPM) utilizes the risk-free rate and 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.

Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders, since payment on debt is required by law regardless of a company's profit margins.


Source : Investopedia