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Assessing the Costs of Debt and Equity

Why did Tesla issue convertible bonds with reasonably short durations while Apple sold standard bonds that pay just cash interest? 

Getting capital to fund operations

Why didn’t Tesla this issue shares of stock as opposed to the convertibles which combines features of both a note and common stock? What are the trade-offs between issuing one type of security debt or equity versus another? What are the potential implications of such a decision? Answering these important questions is the goal of this article.

In order to fund operations and necessary capital expenditures firms turn to any number of potential sources including borrowing money from a bank or other financial institution, issuing notes or bonds to investors and selling shares of stock in the firm.

Other firms issue convertible bonds, a hybrid security that is a combination of a bond that pays interest along with the so-called equity kicker a potential or contingent interest in the issuer stock, but many firms use a combination of all these approaches to raise necessary funds.

Differences between debt and equity

By changing the capital structure of a firm its value may in fact increase or decrease depending on the circumstances and there are some important trade-offs and differences between debt and equity to take into account:

  1. the cost of debt is cheaper than the cost of equity – A typical bond or debt investor anticipates receiving periodic payments of interest and a repayment of the bond’s principal when the bond matures.

    On the other hand, there is going to be much more variability in the ultimate outcome and because of this additional risk investors expect to be appropriately compensated.
    Stocks are obviously more risky than bonds and therefore investors expect a higher return for owning them. Moreover in the event of the insolvency of a firm that has preference over equity in bankruptcy proceedings.

  2. interest payments are tax deductible while dividends paid to shareholders are not – This can be quite significant and encourages increased borrowing and leverage in accordance with national public finance policies.
    Unlike equity debt has a maturity date and must be repaid, debt typically requires periodic payments of interest are like dividends which are issued at the discretion of the company’s management.
  3. shareholders are able to elect a company’s directors and approve certain matters –  Granted most retail shareholders do not usually hold enough shares to sway elections, but they still get to vote while bondholders typically do not.
    Usually this would not have an impact on valuation but it might if say a corporation is closely held with a significant number of voting shares held by one or few individuals.

Assessing the Relative Costs of Debt and Equity

The cost of debt is the interest rate on the debt times one minus the tax rate. The cost of equity is trickier since the cost of such equity is equal to the expected return that an equity investor anticipates from owning that stock and this expected return is in turn derived from asset pricing models like the capital asset pricing model we introduced earlier in this course.

An equity investment in stock is equal to the risk-free rate plus a companies beta times the amount that the overall market is.  Now that we understand both the cost of debt and the cost of equity let’s step back and consider how most capital projects or investments are typically made.  They normally involve a combination of debt and equity.

The weighted average cost of capital

The weighted average cost of capital is extremely important for three reasons:

  1. because it highlights the different cost of debt and equity taking taxes into account;
  2. it reflects the empirical reality as to how capital investments are generally undertaken employing a mix of both debt and equity and
  3. it provides the appropriate discount rate we should use in computing net present values to evaluate investment opportunities.

We can actually use this weighted average cost of capital formula to estimate the cost of capital for an entire company which can be a very important data point for companies chief financial officer in considering whether to approve capital projects or not.

Assessing the Costs of Debt and Equity

To conclude, in exploring these trade-offs we’ve encountered some important concepts:

  1. we seen that debt is not only cheaper than equity but because of the tax deductibility of interest issuing debt instead of equity can increase the value of firms at least marginally.
  2. because investors generally use both debt and equity to fund capital projects we’ve learned that we should consider the weighted average cost of capital associated with any investment. The weighted average cost of capital can then serve as the appropriate discount rate for use in net present value calculations.
  3. we’ve shown how that convertible bonds or hybrid securities highlight the debt and equity trade-off and try to capture the best of both worlds.