Wednesday, July 25, 2007

what is cheaper debt or equity

Please point out flaw in the argument below

Was discussing cost of equity vs cost of debt with a friend of mine with regards to BEML as to why it went for raising high cost equity when it can raise low cost debt considering it has negligible debt on its balancesheet

He raised an interesting point…(although the explanation is simplistic and has obvious flaws, I still think we can refresh our concepts)

Which was that practically cost of equity is nothing in today’s mkts
  • you raise money at premiums of > Rs 1000 (price band of Rs.1020 - Rs.1090 per equity share)
  • and what do you pay as a dividend is a measely 10 Rs dividend (optimistic scenario 100% div on Face value of 10 Rs which it has been paying for the past 2 yrs )
  • what about the other component of return ie capital appreciation … there is no outgo involved for firm
  • so cost for firm -> 10/1020 = ~1%
Consider debt:- you raise money@8 -9 %
  • so cost for firm is 8% (1-tax) = 5.6%

    so which is cheaper equity or debt ???
Equity Dividend 38.29 CR
Equity Dividend (%) 100.00
No of shares in issue – 3.68 cr (PRE FPO issue)

some replies recieved
view 1

If stock is over valued, equity is cheaperThe older shareholders benefit at the expense of the new onesIf the valuation is under valued, that means that the debt servicing capability of the business is much higher in relation to market accorded valuation, in that scenario debt is cheaper

view 2
Though i agree with the logical sense of the argument below, the key to all of this is which is more beneficial to the exisitng investor - that a company raises low cost debt or high cost equity. Eventually, the burden of the higher cost equity will reflect on RoEs and future growth rates of the company. A typical example of this is Gateway Ditriparks which underwent a huge equity raising exercise 2 years back and has been a laggard in the last 1 year

view 3
This is not wrong but ignores the fundamental fact that optimum dilution should be done at a time when company is close to have its valuations move upwards sharply, more so in case of project based company. Till such time, funding needs be better met by debt.