1 Debt financing

Debt financing is when you borrow money from lenders, such as banks, bonds, or loans. The cost of debt is the interest rate that you have to pay on the borrowed amount. The cost of debt is usually lower than the cost of equity, because debt holders have a prior claim on the assets and cash flows of the business in case of default or bankruptcy. Moreover, the interest payments on debt are tax-deductible, which reduces the effective cost of debt. To calculate the after-tax cost of debt, you can use this formula: Cost of debt = Interest rate x (1 - Tax rate)

2 Equity financing

Equity financing is when you raise money from investors, such as shareholders, venture capitalists, or crowdfunding. The cost of equity is the return that you have to offer to the investors to persuade them to invest in your business. The cost of equity is usually higher than the cost of debt, because equity holders have a residual claim on the assets and cash flows of the business after paying the debt holders. Moreover, the dividends or capital gains on equity are not tax-deductible, which increases the effective cost of equity. To calculate the cost of equity, you can use different models, such as the dividend growth model or the capital asset pricing model (CAPM).

3 Dividend growth model

The dividend growth model is a simple way to estimate the cost of equity for a company that pays regular and stable dividends. The model assumes that the dividends grow at a constant rate in the future, and that the cost of equity is equal to the dividend yield plus the dividend growth rate. The formula for the dividend growth model is: Cost of equity = Dividend per share / Current share price + Dividend growth rate

4 Capital asset pricing model

The capital asset pricing model is a more complex way to estimate the cost of equity for a company that does not pay dividends or has uncertain dividend growth. The model considers the risk and return of the company relative to the market, and that the cost of equity is equal to the risk-free rate plus a risk premium. The formula for the CAPM is: Cost of equity = Risk-free rate + Beta x (Market return - Risk-free rate) Where beta is a measure of the systematic risk of the company, and market return is the expected return of the market portfolio.

5 Weighted average cost of capital

The weighted average cost of capital (WACC) is a way to measure the overall cost of capital for a company that uses both debt and equity financing. The WACC is a weighted average of the cost of debt and the cost of equity, based on the proportion of each source of financing in the capital structure. The formula for the WACC is: WACC = Cost of debt x Debt ratio + Cost of equity x Equity ratio Where debt ratio is the percentage of debt in the total capital, and equity ratio is the percentage of equity in the total capital.

6 Comparing the cost of debt and equity

Comparing the cost of debt and equity can help you determine the optimal capital structure for your company, which is the mix of debt and equity that minimizes the WACC and maximizes the value of the company. Generally, a higher debt ratio lowers the WACC, because debt is cheaper than equity. However, a higher debt ratio also increases the financial risk and the probability of default or bankruptcy. Therefore, you need to balance the benefits and costs of debt and equity financing, and consider other factors, such as the availability and flexibility of funds, the growth and stability of earnings, and the industry and market conditions.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?