if cost of debt always lower than cost of equity, then

CFA Level II
#1

If cost of debt must be lower than cost of equity, then why dont we use debt to finance all project??

#2

The higher the leverage, the higher the risk of default and hence the higher the cost of debt.

This relation holds with the exception of the US. Mortgages at 0% downpayment and even commission kickbacks. We’ve all paid for this scam.

#3

Look at Modigliani and Miller: they conclude the same thing when they ignore the possibility of bankruptcy. Once you add in that possibility, the cost of debt increases as the percentage of debt increases. Thus, there is some point of minimum WACC: that’s the optimal capital structure.

#4

You passed all three levels without understanding this concept?

#5

I passed all three levels (the first time through . . . not that that makes me a better analyst), and I don’t understand any of this stuff. I just Google it. (And, frankly, I don’t even understand Google.)

#6

S2000 my question wasn’t directed at you. I know you are a scam.

Just curious why a charterholder would post a basic question revealing the lack of fundamentals on a Level 2 forum. There might be a logical answer to this though. No judging!

#7

debt service requires you to have significant cash flow. If you’re a growing company that’s operating in the red, either your interest rate will be astronomical or you’ll have your assets called against you before you start making money

#8

I knew that it wasn’t directed at me, and I wasn’t answering it, per se. I was defending the OP.

It was only a matter of time.

#9

I am honestly shocked that a charterholder asked that question… my dad could have told you the answer.

#10

That means your dad knows how to use google or is called S2000, or both. In either case pretty cool.

#11

thank you for everyone’s help. I major in science and self study and pass in a short time, so I did miss or skip some concepts or content.

If a company want to invest in a project and that company currently have a lot retained earning. Then the boss say we should use our own money to fund it since we have those money in our company already and we dont have to pay interest for it. But if cost of debt must be lower than cost of equity, shall the company borrow money even it has a lot money on hand already?

I am sorry if this question is too simple again

#12

If you can do it, all of us can. Thumbs up!

#13

Okay, no more jokes :slight_smile:

If you are talking about a small company particularly a sole proprietorship, then yes, you MAY be better off just using the company’s reserve to fund projects if you have extra cash and don’t have any other investment plans. But in reality, cash on hand is usually “tight” because most businesses would like to keep their cash at minimum to maximize return.

Think about it, if a company has $1M at any given time (revenue > expenses), wouldn’t it make sense to invest that money somehow to generate more money? if not in an internal project, at least make term-deposits to earn some interests if not putting it in some other short term investment accounts. So in a way, any cash on hand can potentially generate return, so it makes sense to analyze whether to borrow money, at a cost but also with tax benefit, or to use internal funds.

NANA

#14

Yes you should be sorry.

#15

same here…forgot almost everything after exam

let me try this…

use of retained earnings is the cheapest alternative, no costs of borrowing, and sends a signal to investors that the company is financially in a strong position. boosts image and maybe stock price. due to the expansion, dividends need not be paid out.

normally will not borrow if can use RE, but normally Cash Flow is needed. so its really up to the company. if just mainly due to costs of borrowing, debt. but of course there are other things to consider. bringing up the profile of company, company’s long term goals, etc…all these will affect whether the choice is debt or equity financing…

hope im correct…

#16

Are you serious man? Are you trying to advertise for your company with this trivial crap? Holy cow, I deeply feel for all your students.

#17

Thanks for all the reply, I have read some books again and I think I have an explanation for my own question

If you start with 100% equity at begin, then using more debt will lower the WACC because cost of debt is always lower than cost of equity

However as the percentage of debt that you use increase, both the cost of debt and equity increase as the firm become risker as leverage increase, so at the later stage, when you use more debt, your WACC will actually increase

So it is true that cost of debt is always lower than cost of equity, but it is not true that more debt always lead to lower WACC

So if you have a lot retained earning now and if you want to finance a new project, in theory you should use debt to lower WACC. But in reality, many manager would prefer to use RE because the pecking order theory explain that manager prefer internal funding more than issuing debt and stock

#18

In a word: Bingo!

(Note: just because you have a lot of retained earnings doesn’t mean that you can finance a project internally. For that you need cash.)