Cost Of Debt

Why the cost of debt is different from the cost of equity 

Companies can raise money through stock or debt, with the majority opting for a mix of both. If a company is entirely funded by equity, the cost of capital is the rate of return that should be given to shareholders. The cost of equity is the term for this. Because debt often supports a portion of capital, debt holders should be provided with the cost of debt. The primary difference between the cost of stock and the debt is that the former helps shareholders, while the latter benefits loan holders.

Because the Cost of Equity does not pay interest, it is not tax-deductible, but the Cost of Debt is tax-deductible owing to interest payments.

The main distinction between the cost of equity and the debt is determined by who should receive the returns. The cost of equity should be addressed for shareholders, and the cost of debt should be computed if it is for debt holders. Even while debt offers tax benefits, a high proportion of debt in the capital structure is not considered healthy.

Difference between the real risk-free rate and the nominal risk-free rate of interest

The risk-free rate is the yield on the safest bond, such as government bonds and treasury bills. You earn a nominal rate of interest, which is then adjusted for inflation to produce a real interest rate.

In essence, the real risk-free interest rate is the rate of return that investors demand on zero-risk financial instruments not subject to inflation. The actual risk-free interest rate is a theoretical term since it does not exist. However, studies have shown that the actual risk-free interest rate is equal to the economy’s long-run growth rate, even though it cannot be seen in any meaningful way.

The nominal risk-free interest rate is the observed return on a risk-free asset. The nominal risk-free interest rate may be calculated by multiplying the actual risk-free interest rate; however, you compute it by the inflation rate. The most crucial thing to remember about these two ideas is that the inflation rate determines their connection.

The interest rate used to assign value to an asset

Consider having a simple asset such as an apple tree. The apple tree provides a revenue stream through fruit that can be sold. This tree’s worth may be considered the highest price you would be prepared to pay for an apple tree or the tree’s valuation. Connect this figure to the cost of an apple tree.

Begin by assuming the apple tree is basic. It will produce precisely one apple harvest the following year. That apple will be worth $1 next year. The tree will, after that, perish. Assume that everything of the above is true. The value of an apple tree today is determined by the worth of $1 next year.

A dollar will not be worth the same next year as it is this year. If you have a dollar this year, you may deposit it in the bank and earn interest. To calculate the worth of a dollar today, divide it by the nominal interest, the interest rate used to assign value to an asset  according to the discounted present value technique: