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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

Which statement about the cost of debt and cost of equity of a company is correct?

Debt is normally cheaper than equity. Lenders rank ahead of shareholders in claims on income and assets, so they bear less risk and accept lower returns, and interest is usually tax deductible, which reduces the effective cost of debt further.

  1. ACost of equity is normally lower than the pre-tax cost of debt because shareholders are paid dividends first.
  2. BDebt is normally cheaper than equity because lenders have priority on claims and interest is usually tax deductible.Correct
  3. CTax relief on interest raises the post-tax cost of debt above its pre-tax cost.
  4. DCost of equity is unaffected by gearing because dividends are discretionary.
  5. Cost of debt equals the coupon rate regardless of the market price of the debt.

Explanation

Lenders rank ahead of shareholders and face less risk, so they require lower returns, and interest tax relief lowers the post-tax cost further. Tax relief reduces, not raises, the cost. Higher gearing increases financial risk for shareholders and so raises the cost of equity.

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