• Debt Financing versus Equity Financing

Debt financing is where a firm raises money for capital by selling debt instruments to investors. By lending money to a firm, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be eventually repaid on agreed terms.

On the other hand, equity financing is where a firm raises capital through selling shares of a company, and investors become shareholders and own a proportion of interest in the company. Shareholders receive dividends each year but not the principal of the sum invested.

• Cost of Debt versus Cost of Equity

Cost of equity is the percentage return demanded by company’s shareholders. Equity providers usually bear higher level of risk compared to debt providers, hence equity return should be higher than the cost of debt. For example, if the cost of equity is calculated to be 10%, the business must strive to increase the amount that shareholders have invested by 10% to keep them happy. The Capital Asset Pricing model (CAPM) allows us to estimate the cost of equity:

• Risk-free rate of return = the minimum return or interest rate an investor would expect from an absolutely risk-free investment such as government bond.
• Equity Beta (β): the measure of how risky a share is relative to the market.
• Equity risk premium = the difference between the market return and the risk-free rate.

On the other hand, cost of debts is the rate of return demanded by lenders/debtholders. The return required (cost of debt) is typically the interest rate that the lenders charge on the money lent. Lenders generally face lower risk than shareholders because debt is usually backed by company assets. In the case of bonds, the cost of debt can be calculated using the following formula:

   Cost of Debt = (coupon rate/market price) x 100%

• Coupon rate = the interest rate paid by the bonds.

• Cost of Capital

The cost of capital is made up of cost of equity plus cost of debt. The overall cost of funding a project depends on the proportion of each type in the capital structure, and this is known as weighted average cost of capital ‘WACC’, which can be calculated using the following formula:

To reiterate, weighted average cost of capital ‘WACC’ is the mixture of the cost of debt and cost of equity, which gives the business owners an idea of the minimum return that the business must generate to keep its investors (ie: lenders and shareholders) satisfied. It is important to know the WACC of a business to gauge the expense of funding future projects.