Question

Explain how the (i) Cost of debt and (ii) Cost of Equity affect the choice of capital structure.

Answer 1

• Cost of Equity- Equity shareholders expect a return on their investment, i.e. Earning Per Share (EPS). When a company increases debt, the financial risk faced by the equity shareholders increases and then EPS starts decreasing with inclusion of debt, then beyond this point, cost of equity may go up sharply and share price may decrease.
  
• Cost of debt- It may be defined as the payment made by company to obtain capital. Thus, interest is the cost of debentures or loan and dividend paid by the company is the cost of equity and preference share capital. The rate of dividend on preference shares is fixed which is generally lower than that of equity shares. The cost of debentures is generally lower and tax deductible.