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Asked by Subhash Last Modified
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Cost in this context refers to the cost of obtaining capital. In the case of debt, the cost is interest whereas in the case of equity share capital, it is the share in the profits of the company. Suppose, a company has a profit of Rs 6,00,000 and Equity capital of Rs 50,00,000, requires funds has to choose between taking a debt of Rs 10,00,000 carrying interest at 10% or giving out a equity stake of 20%. If the debt option is chosen, the cost of the debt will be 10% of Rs 10,00,000 which is 1,00,000 and that leaves Rs 5,00,000 to the equity shareholder. If the equity financing choice is opted then new shareholder will get 20% of the profits which is Rs1,20,000 which is clearly higher than the cost of the debt. Additionally, interest on debt is a tax deductible expense, whereas, dividend paid to shareholders is charged under corporate tax. A company cannot work only with debt because of the risk that a company may fail to generate enough cash flows to pay interest and repay debt.
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Mrs Prejna
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