Question

1. WACC

What role does the cost of capital play in the overall financial decision making of the firm’s top managers?

2. DEBT VS EQUITY

Why do you think debt offerings are more common than equity offerings and typically much larger as well?

Answer 1

1. Cost of capital is the basis in determining the benchmark rate in taking financial decisions. Every financial decision involves evaluation of income from the project in monetary terms, measured in terms of rate of return. And the rate of return thus estimated is compared with the benchmark which comprises of Cost of Capital employed with a mark-up. The mark-up or the spread is determined based on the risk perception of the industry or project and the required net profit.

Thus, cost of capital serves the purpose of judging on the acceptability of a project.

2. Equity, by nature, carries much more risk for the investor as well as the issuer. For investor, there is no assurance of repayment of the amount invested or for any income on it. It depends on the income generating capacity of the issuer. On the other hand, debt has a contractual obligation to repay the principal and pay interest at the agreed rate, at the agreed time. Hence, investors feel safer in investing in debt, compared to equity. This is notwithstanding the fact that equity investments offer unlimited potential for income in the form of capital gain and dividend income. But in the case of debt, income is pre-determined.

For the issuer, equity offering will result in diluting his stake which may, eventually lead to change of ownership and control of the company. Most of the promoters do not prefer to have such an outcome. In addition to that, the unique advantage of the equity investor ie., unlimited potential for income generation, is a drain for the issuer. Hence, for a promoter, it is safer to issue debt/ borrow money rather than issue of equity.

Another reason is the extensive regulatory compliance involved in issuing equity and the high cost involved in flotation.

For all these reasons, debt offering is more common and larger in size when compared to equity offering.