Aswath Damodaran 314
Costs of Debt & Equity
A recent article in an Asian business magazine argued that equity was cheaper
than debt, because dividend yields are much lower than interest rates on debt.
Do you agree with this statement
# Yes
# No
Can equity ever be cheaper than debt?
# Yes
# No
No. Dividend yields are only a portion of what you have to deliver to equity
investors to keep them satisfied (To which, the Asian manager might well
respond: What if they are not satisfied? What can the do to me? The more
power stockholders have over managers, the more likely it is that they will
subscribe to viewing cost of equity as including dividend yield and price
appreciation)
Equity can never be cheaper than debt for any firm at any stage in its life cycle,
since equity investors always stand behind debt holders in line when it comes to
claims on cash flows (each year) and on assets (on liquidation). I know.. I
know.. There is one exception. If you have a company with a negative or very
low beta, its cost of equity may be so low that it is lower than the default-risk
adjusted cost of debt. Such a company should never borrow money in the first
place, making the exception moot.
