A few days ago, I was walking through a shop when I came across a snack I hadn’t seen in years. It was one of those snacks I used to love as a child, and for a moment I just stood there looking at it.
I couldn’t quite remember the last time I had eaten it, but somehow I could remember everything around it: those little neighbourhood shops we used to go to when we were young, the shelves packed far too closely together, the sweets hanging near the counter, and that very particular excitement of being allowed to choose something for yourself when you only had a few coins in your pocket.
Back then, every few cents felt enormously important. You could stand in front of the shelf for what felt like forever, trying to work out whether buying the chocolate meant giving up the crisps, whether two smaller sweets were somehow a better deal, or whether, if you searched every pocket carefully enough, another coin might magically appear.
Every now and then, after counting everything several times and discovering that the answer was still no, there was one more possibility.
Someone else had money.
Maybe we asked our parents for a little more. Maybe we turned to our brother or sister and asked to borrow fifty cents, usually accompanied by an extremely confident promise that we would give it back the next time we got our pocket money.
Sometimes they agreed, sometimes they didn’t, and sometimes fifty cents somehow became the subject of a negotiation far more serious than fifty cents had any right to be.
Looking back, I find it funny how early most of us understood what was happening.
If we wanted to spend our own fifty cents, there wasn’t much to discuss. But the moment we wanted somebody else’s fifty cents, suddenly there were conditions.
I’ll give it back tomorrow. You can have some of mine. Fine, but this comes out of next week’s pocket money.
We didn’t know anything about interest rates, required returns or the cost of capital.
We just understood, in the uncomplicated way children understand these things, that if somebody gave us money that belonged to them, there was usually something we had to give them in return.
Eventually, of course, fifty cents stopped being a problem.
We grew up, started earning our own money and became perfectly capable of buying the snacks we wanted. Unfortunately, the things we wanted became more expensive too, and somewhere between fifty cents for sweets and hundreds of thousands for a home, a business or an investment, that little negotiation we had been having as children became an entire subject in finance.
Because companies spend a lot of time wanting things they cannot yet afford too.
Building factories, buying equipment, acquiring another business or investing in projects they believe will make money in the future.
But believing something is worth doing and having the money to do it are two different problems.
Somehow, the money has to come from somewhere.
And this is where things become slightly less obvious than borrowing fifty cents from our brother.
Not all money looks borrowed
When we think about a company using somebody else’s money, debt is probably the first thing that comes to mind.
A company goes to a bank and borrows €1 million. The bank provides the money, the company uses it for whatever it needs, pays interest while it has it and, eventually, gives the €1 million back.
We recognise immediately that the money does not really belong to the company. It has simply been allowed to use it for a while.
But imagine the company gets the same €1 million by issuing shares instead.
An investor provides the money and, in return, becomes one of the owners of the business. There is no €1 million loan sitting there waiting to be repaid and no date in the future when the company has to find the money and return it.
Somehow, this doesn’t feel quite as much like using somebody else’s money anymore.
It becomes even easier to miss when the person providing the equity is us.
Imagine we start a business and put €100,000 of our own savings into it.
There is no bank involved, no interest payment waiting at the end of the month and no outside shareholder asking what return they are going to receive. It is our money going into our company, and I think that makes it very easy to treat the €100,000 as though it came to us for free.
Except it didn’t.
Had we not put it into the business, perhaps we could have invested it somewhere else and earned 6%. We might never physically pay ourselves that missing €6,000, and it will never appear on the company’s bank statement as an expense, but we still gave it up when we chose one use for the money over another.
The €100,000 had alternatives before we put it into the business. Once we chose our company, we gave those alternatives up.
And that changes the way I think about what it means for capital to have a cost.
Capital does not need to be borrowed to have a cost.
A bank requires a return because it could have lent its money elsewhere. An investor requires a return because they could have invested somewhere else. Even when the money is our own, putting it into the business means giving up whatever return it could have earned somewhere else.
What changes is what the person providing that money needs in return before giving it to us becomes worthwhile.
Debt makes that return relatively easy to see.
Equity is where it gets interesting.
The cost we already understood
Let’s go back to the fifty cents.
Perhaps our brother eventually agreed to lend it to us, but by then he had realised there was something in this for him too.
So maybe the deal became: Fine, I’ll give you fifty cents today, but when you get your pocket money tomorrow, I want my fifty cents back. And I get one of the sweets.
At the time, we probably weren’t thinking very deeply about what had just happened. We had the extra fifty cents, which meant we could finally buy what we wanted, and giving away one sweet probably felt like a small enough price to pay.
But there are actually two different things happening inside that agreement.
The fifty cents we give back tomorrow isn’t really what the money cost us. It belonged to our brother in the first place. We borrowed it, used it for a while and then returned what we had taken.
The sweet is different.
Had we had enough money ourselves, there would have been no reason to give our brother anything at all. We gave up the sweet specifically because he allowed us to use money that belonged to him.
Without knowing it, we already understood the basic idea behind the cost of debt.
Companies may call the fifty cents principal and replace the sweet with interest, but the exchange underneath it is surprisingly familiar: you can use my money now, but using it is going to cost you something.
Suppose a company borrows €1 million at 5%. It gets the €1 million it needs, and in return it agrees to pay the lender €50,000 a year. Eventually, depending on the terms of the debt, it also returns the €1 million.
Now imagine the company has an extraordinary year. The investment succeeds beyond anyone’s expectations, profits soar and the company makes far more money than anybody thought it would.
The lender still gets €50,000.
Now imagine the year goes the other way. Sales disappoint, costs rise and the company makes far less than expected.
The lender still wants €50,000.
I think the two years need to be looked at together because that is where the bargain becomes clearer. The lender gives up much of the upside. In exchange, it gets a stronger claim over what it was promised. Its interest does not automatically rise when the company succeeds, but neither does it politely disappear when the company has a bad year.
Lenders generally stand ahead of ordinary shareholders when payments are made, and if the company eventually fails, they normally have a stronger claim on whatever remains. None of this means debt is safe. Lenders can still lose money. But compared with shareholders, more of the uncertainty has been taken away from them.
And if we were the ones providing the money, that would matter.
If somebody offered us 5% with a contractual claim and another investment offered the same expected 5% without those protections, why would we choose the second one?
Most likely, we would ask for more.
That is one of the reasons debt tends to be cheaper than equity. The lender is not simply being generous by accepting a lower return. It is accepting a different deal.
The strange thing about tax
If the company borrows €1 million at 5%, the cost seems fairly easy to identify. Five per cent of €1 million is €50,000. That is what the lender receives, so €50,000 must surely be what the debt costs the company.
Except when we calculate the cost of debt in finance, we often say it costs less than that.
The first time I came across this, I remember the logic feeling slightly strange because the lender clearly had not agreed to take less. If we owe €50,000 of interest, we still pay €50,000. Nothing about the loan agreement has changed.
So where exactly did the saving come from?
It comes from a completely different payment.
Suppose the company earns €200,000 before interest and tax, and corporation tax is 25%. Without the interest expense, the company would pay €50,000 in tax.
Now add our €50,000 interest payment. The lender still receives every euro it was promised, but because interest is generally deductible when calculating taxable profit, tax is now calculated on €150,000 instead.
At 25%, that gives us tax of €37,500.
So the company paid €50,000 to the lender, exactly as promised, but because that payment existed, it paid €12,500 less to the tax authority.
The interest itself did not somehow shrink from €50,000 to €37,500. We simply have to look at both sides of what changed.
Pay €50,000 here. Save €12,500 there.
The net effect is €37,500.
Which means that, from the company’s side, debt carrying a 5% interest rate at a 25% tax rate effectively costs:
5% × (1 − 25%) = 3.75%.
And now debt starts to look almost unfairly attractive. Lenders generally require a lower return because they have greater protection, and the tax treatment of interest can reduce the effective cost to the company even further.
Which raises a rather obvious question.
If debt is so cheap, why would a company ever choose the more expensive alternative?
Before we can answer that, we need to understand what exactly makes equity expensive in the first place.
The cost that never sends us a bill
Imagine the same company gets its €1 million by issuing shares instead.
An investor gives the company the money and becomes a shareholder. There is no €50,000 interest bill waiting at the end of the year, no date five years from now when the company has to return the original €1 million, and no fixed payment an ordinary shareholder can simply demand because another year has passed.
The company might pay a dividend. It might pay a smaller dividend next year. It might decide that keeping the money inside the business is more valuable and pay nothing at all. Exactly how companies make those choices takes us into dividend policy, which deserves a discussion of its own.
But for now, this leaves us with a strange situation.
The lender gave the company €1 million and we could see the cost almost immediately. There was interest, repayment and an agreement telling us what had to happen.
The shareholder also gave the company €1 million.
But where is the cost?
If we searched through the bank statement looking for an annual “cost of equity” payment, we might never find one. For something finance insists is usually more expensive than debt, equity does a remarkably good job of looking free.
And I think the reason is that, until now, we have been standing on the wrong side of the transaction.
What if the €1 million were ours?
Suppose we have €1 million sitting in front of us, and we are trying to decide what to do with it. Perhaps there is somewhere relatively safe we could put it and expect around 4%. We are not going to become enormously wealthy from it, but we have a reasonable idea of what we are getting.
Then somebody asks us to put that same €1 million into their company as equity.
This time, there is no promise of 4%, or 5%, or anything else. If the company becomes enormously successful, that might turn out to be wonderful for us. Profits may grow, dividends may rise and the shares we bought for €1 million might eventually be worth considerably more.
But the other direction is just as real.
Profits may fall. Dividends may disappear. The share price may decline. And if the company eventually fails, the lenders have stronger claims than we do over whatever is left.
So imagine both choices were expected to give us the same 4%.
Would we really be indifferent between them?
I don’t think most of us would be. If one investment gives us considerably more uncertainty but offers nothing extra for accepting it, there is very little reason to choose it.
Perhaps 6% would make us think about it. Perhaps we would need 8%, or 10%, or considerably more depending on the company and the risk we were being asked to take.
And now the cost we could not see from inside the company begins to appear.
The company never promised to pay us 10%. But if 10% is the return we need before we are willing to put our €1 million into this company rather than somewhere else, then the company has a problem if it cannot offer us a return worth taking that risk for.
From our side, 10% is the required return.
From the company’s side, the same 10% becomes the cost of equity.
Nothing changed except where we were standing.
And this is why equity can have a very real cost without having anything that looks like an interest bill. The cost does not come from a compulsory payment written into a contract. It comes from the return investors require before they are willing to provide the money at all.
The problem with a cost we cannot see
Understanding that equity has a cost creates another problem almost immediately.
How do we know what it is?
With debt, we usually have something relatively concrete to work with. Shareholders do not sign a contract saying, My required return is 9.6%.
So finance has to estimate it.
There are different ways of doing that. We can look at dividends and expected growth through the Dividend Growth Model, or approach the question through risk using CAPM (Capital Asset Pricing Model).
The calculations are different, and both deserve their own discussion. But underneath them, I think they are trying to answer the same question we have been asking all along:
What would somebody need in return before giving us their money becomes worth it?
By now, debt appears to have won this comparison rather comfortably.
Which is exactly where the next problem begins.
If debt is cheaper, why not just use debt?
Suppose the company can borrow at an after-tax cost of 4%, while its shareholders require 10%.
If it needs another €10 million, the answer seems almost too easy.
Why would we choose money costing 10% when somebody is willing to give us money for 4%?
Perhaps we should borrow the €10 million. And if that works, perhaps the next €10 million should be debt too.
In fact, if debt really is this much cheaper, why not use as much of the cheap money as possible?
The problem is that the 4% and 10% do not necessarily sit still while we do that.
Imagine a company with no debt. In a good year, its operating profit is €1.4 million. In a difficult year, it falls to €600,000.
Now suppose the company borrows heavily and has €500,000 of interest to pay every year. Nothing about the underlying business has necessarily changed. It can still make €1.4 million in the good year and €600,000 in the bad year.
But before the shareholders get anything, somebody else has to be paid.
In the good year, €1.4 million becomes €900,000 after interest. In the bad year, €600,000 becomes just €100,000.
The lender’s claim did exactly what we said it would do earlier.
It stayed fixed.
That greater certainty was one of the reasons debt was cheaper in the first place. But if the lender gets more certainty about what it will receive, somebody else has to absorb more of whatever changes.
That somebody is the shareholder.
This is financial gearing, and it deserves an article of its own. For now, the important part is what it does to the question we started with.
If we were perfectly happy requiring a 10% return before all that debt was added, would 10% still be enough now that our position is riskier?
Perhaps not.
And suddenly the apparently simple decision to replace expensive equity with cheap debt has changed the price of the equity that was already there.
Keep borrowing and eventually lenders may start looking at the company differently too.
So yes, debt is normally cheaper than equity. But we cannot keep adding cheap debt and assume everything else stays where it was.
The question is no longer simply:
Which source of money is cheaper?
It becomes:
What happens to the cost of one when we change how much we use of the other?
And now we have two costs
We started with fifty cents.
We wanted something we could not quite afford, somebody else had the money, and even as children we understood that they might want something before they were willing to let us use it.
Debt turned that exchange into something formal. The lender gives us money, we promise interest and repayment, and because the lender has stronger claims and greater certainty, the return they require is usually lower.
Equity removes many of those promises, but removing the promises does not remove the cost. It moves more uncertainty onto the person providing the money, and that person usually wants a higher expected return before taking it.
From their side, those numbers are required returns.
From the company’s side, they are costs of capital.
But a real company usually has both.
Perhaps its debt costs 5%. Perhaps its equity costs 10%. Perhaps 30% of its financing comes from debt and 70% from equity.
Then one day the company finds a project expected to return 8%.
Is 8% good?
It is higher than the cost of debt, but lower than the cost of equity.
So which number should we compare it with?
Neither, at least not on its own.
Somewhere between what lenders require and what shareholders require is the return the company as a whole needs to earn for using both kinds of money.
And that is where we get to the weighted average cost of capital.
But we’ll leave that one for next time.
