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CS Executive · Corporate Accounting and Financial Management · Cost of Capital

Which of the following is the correct reason why, for the same company, the explicit cost of equity share capital is generally higher than the cost of debt?

Equity costs more than debt because shareholders carry higher risk. They are paid after lenders, have no assured return and bear the residual claim, so they require a higher return. Debt also benefits from the tax deductibility of interest, which lowers its effective cost further.

  1. AEquity holders bear greater risk, as they are paid only after lenders and have no assured return, so they expect a higher returnCorrect
  2. BInterest on debt is not tax deductible but dividend is
  3. CEquity capital never requires any flotation cost
  4. DDebt holders have a residual claim on profits

Explanation

Equity holders rank last in claims on income and assets and receive no fixed return, so they demand a risk premium. In reality interest is tax deductible while dividend is not, which makes the second option reversed. Debt holders have a fixed prior claim, not a residual one, and equity does involve issue costs.

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