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Work out the cost of each source of finance, including the after-tax cost of debt two ways, and explain why the ordering between them is always the same
The question, in plain words
A company needs money. It can sell new shares, it can borrow, it can issue something in between, or it can simply not pay out the profit it already has. Each of those is a source of finance, and each one has a cost.
The cost of a source is not the cheque the company writes. It is the return the provider of the money requires in order to hand it over. Nobody lends or invests out of goodwill; they do it because they expect a return, and that expected return is the company's cost whether or not it ever appears as an expense in the accounts.
That single sentence settles a question that confuses people for a whole term: retained earnings are not free. The shareholders could have had that cash. Keeping it means they are investing it in the company again, and they expect the same return on it that they expect on the rest of their shareholding.
Why the ordering exists, before any numbers
Put a company into difficulty and there is a strict queue for whatever money is left. Lenders are paid first. Preference shareholders come next. Ordinary shareholders get whatever remains, which is often nothing.
Being last in that queue is riskier than being first, and a rational investor charges for risk. So the required return rises as you go down the queue, which means the cost to the company rises in exactly the same order:
In words: the safer the claim, the cheaper the money. This is a mechanism and not a rule of thumb, and it is why a question that produces a cost of equity below a cost of debt has an error in it rather than a finding.
Tax widens the gap further, and this is the part worth being precise about. Interest on debt is an expense, so it reduces taxable profit and the company recovers part of it as tax relief. A dividend — ordinary or preference — is a distribution of profit that has already been taxed, so there is no relief. Debt is therefore cheaper than the queue alone would make it.
The four sources, and what each one costs
Ordinary shares
The owners. They vote, they get whatever is left after everyone else, and nothing is promised to them. Their required return is the cost of equity, and the dividend growth model is the standard way to infer it from a share price:
In words: the dividend you are about to receive as a fraction of what you pay for the share, plus the rate at which you expect that dividend to grow. The first term is the income and the second is the growth, and a share is worth holding for both.
The model rests on a real assumption — that dividends grow at a constant rate forever — and the honest thing is to say so. It is a way of reading a required return out of a price, not a law.
Retained earnings
The cheapest to arrange and the most frequently mispriced. There is no issue cost, no prospectus and no negotiation, so it feels free. Its cost is the cost of equity, because it is the shareholders' money being reinvested on their behalf. A company that accepts a project returning 9% because "it is funded from reserves, which cost nothing" while its shareholders require 13% is destroying value at a rate of 4% a year on that money.
Preference shares
A fixed dividend, paid before ordinary dividends and after interest. Usually no vote. The dividend is normally cumulative, so a missed year accumulates rather than disappearing — but it can be missed without putting the company into default, which is the crucial difference from interest.
No growth term, because the dividend does not grow. No tax relief, because it is a dividend. That combination is why preference shares have largely gone out of fashion as a financing choice: they carry debt's inflexibility of return without debt's tax advantage.
Debt
Interest must be paid whether or not there is a profit, and failure to pay it is default. In exchange the lender accepts a lower return and usually takes security. For irredeemable debt the gross cost is the interest as a fraction of the market price, and then tax relief is taken off:
kd (after tax) = kd (gross) × (1 − t)
Two points that cost marks. The denominator is the market price, not the nominal or par value; the company's cost of raising a further rupee depends on what a rupee of its debt currently sells for. And for redeemable debt the cost is the internal rate of return on the whole stream — the interest plus the redemption amount — which is a different and larger calculation.
Hybrids, which are a choice rather than a category
A convertible bond is debt that the holder may later exchange for shares. A warrant is a right to subscribe for shares attached to an issue. Both let a company borrow at a lower interest rate than it otherwise could, because the holder is being handed something extra: the upside if the share price rises.
That lower interest rate is not a free lunch, and treating it as one is the mistake this topic punishes. The company has sold an option over its own shares. If the shares do well the conversion happens, the existing shareholders are diluted, and the true cost of that money turns out to have been well above the coupon. The coupon is what you pay in cash; the cost is the coupon plus the option you gave away.
Where a quotation fits
Obtaining a Stock Exchange quotation is not itself a source of finance — it is a change in how easily the existing and future shares can be sold. It widens the pool of buyers, gives the shares a visible price, and makes later issues easier and cheaper. Against that it brings continuing disclosure, the cost of compliance, a dispersed shareholder body with less patience, and a price that reacts publicly to bad news. A question asking whether a company should seek a quotation is asking you to weigh those, not to recite them.
Questions students ask
If debt is the cheapest, why does any company issue shares?
Because debt has to be serviced in bad years as well as good ones, and a company that cannot pay its interest loses control of itself. Cheap money that must be repaid on a fixed date is not the same product as expensive money that need never be repaid at all. The next page but one, on Modigliani-Miller, is where this trade-off is made precise.
Does a company's cost of capital depend on who provides the money?
No, and this is worth getting straight early. The required return depends on the risk of what the money is invested in, not on the label attached to the finance. A low-risk project does not become high-risk because it was funded by equity. This is the single most useful idea in the whole of the cost-of-capital topic, and the reason a company appraises a project at a blended rate rather than at the cost of whichever source it happens to draw on.
Why does the cost of equity have a growth term when the cost of debt does not?
Because the payment grows. An ordinary dividend is a share of a profit that one hopes will rise; a coupon is a fixed amount fixed in the contract. A shareholder buying at today's price is paying for the whole future stream, including its growth, so the return they require has to be expressed against a growing stream.
A worked example
An invented company, built for this page. Every figure below is made up for the example and describes no real company, security or market.
Shringar Tools Limited is financed four ways. Corporation tax is 25%.
| Source | Terms | Market price |
|---|---|---|
| Ordinary shares | next dividend ₹8 a share, expected to grow 5% a year | ₹100 |
| Preference shares | 9% on a ₹100 nominal value, so ₹9 a share | ₹90 |
| Irredeemable debentures | 8% on a ₹100 nominal value, so ₹8 interest | ₹95 |
| Retained earnings | profit kept rather than distributed | — |
Ordinary shares
ke = 8 / 100 + 0.05 = 0.08 + 0.05 = 0.13 → 13.00%Eight per cent of it is income and five per cent is growth. A student who reports 8% has priced a share that will pay ₹8 forever, which is not the share described.
Preference shares
kp = 9 / 90 = 0.10 → 10.00%Note that the 9% on the face of the security is not the cost. The cost is 10%, because the share sells for ₹90 rather than ₹100. Using the coupon would understate it by a tenth.
Debentures, before tax
kd (gross) = 8 / 95 = 0.0842105 → 8.421%Debentures, after tax, by two routes
Route one. Take the gross cost and remove the tax relief:
0.0842105 × (1 − 0.25) = 0.0842105 × 0.75 = 0.0631579 → 6.316%Route two. Work out what the interest actually costs the company after relief, and divide by the price:
interest ₹8, tax relief 25% of 8 = ₹2, net cost ₹6
6 / 95 = 0.0631579 → 6.316%The same figure to seven decimal places, and necessarily so: dividing by 95 and multiplying by 0.75 can be done in either order. Route two is the one to reach for when a question mixes tax rates or gives relief with a delay, because it keeps the cash flows visible instead of hiding them inside a factor.
Retained earnings
cost of retained earnings = ke = 13.00%No calculation, and that is the point. It is the shareholders' money, so it carries the shareholders' required return.
The ordering, as a check
Source Cost Tax relief? Debentures, after tax 6.32% yes Preference shares 10.00% no Ordinary shares 13.00% no Retained earnings 13.00% no In the order the payment queue predicts, and with the tax-relieved source furthest below the rest. If a calculation of yours ever puts these out of order, the arithmetic is wrong — you do not need to inspect it to know that.
Look at the size of the gap, too. Equity costs more than twice what debt costs after tax, 13.00% against 6.32%. That ratio is the whole reason capital structure is a question at all, and the reason the Modigliani-Miller argument comes as such a surprise when you first meet it: given a gap that large, it seems obvious that a company should borrow as much as it possibly can.
And the convertible, to show what the coupon hides
Suppose the company could instead issue a convertible debenture at a 5% coupon, each ₹100 nominal convertible into 20 ordinary shares at the holder's choice in five years.
Five per cent looks cheaper than eight. But at today's share price of ₹100, twenty shares are worth
20 × ₹100 = ₹2,000against ₹100 of nominal value. The conversion right is already worth many times the debt, so conversion is near-certain and what the company has really done is agree to sell twenty shares for ₹100 while paying 5% in the meantime. The coupon saving of three percentage points is trivial beside that. A convertible priced like this is equity wearing a bond's clothing, and the cost to existing shareholders is dilution, not interest.
Where this fits in CB1
This page explains one idea from CB1 Business Finance. The full CB1 syllabus, with what each part is examined on, sits on the course page, and past-paper style mock exams with full solutions are where you find out whether the idea has stuck under time pressure.
Other CB1 topics explained
- Why financial reporting is regulated, and who it is regulated for
- Leasing against buying, and the only comparison that settles it
- Profit is not cash, and why a growing company can run out of money
- Return on capital employed, and the two things that drive it
- Gearing: why borrowing magnifies a shareholder return in both directions
- Modigliani-Miller: why gearing does not create value, and what does
- Dividend irrelevance, and the four reasons dividends still matter
- The cost of capital, and why a project must beat the whole pot
- NPV against IRR, and the three times IRR gives the wrong answer
- Working capital: the days between paying out and being paid
- Valuing a company: discounted cash flow against comparable multiples
- Synergies and the takeover premium: who actually gets the gain
- Company tax in an appraisal, and the relief that reverses the answer
- Interest rate swaps: fixing a floating cost, and where the saving comes from
- Hedging currency risk: the forward contract and the money-market hedge
Stuck on a term rather than the idea? The actuarial glossary defines the notation used above. If something here is wrong or unclear, tell us — these pages get corrected.