Question

Q.Can you please explain to me the difference between cost of equity and cost of capital? For a geared entity, how would raising equity finance impact on the cost of equity?

Answer 1

Cost of capital is the minimum expected return which the company is expected to earn to on the investments made by the company. It is often used for capital budgeting decisions.

Cost of capital is calculated by Weighted average cost of capital (WACC )

Weighted average cost of capital (WACC ) is the ratio that calculates the company’s cost of capital by comparing the debt and equity portion in the business.

WACC = Cost of equity * Weight of equity + Post tax cost of debt * Weight of debt

As we can see that Cost of equity is a part of WACC i.e Cost of capital.

For a levered company, the cost of capital is lower as compared to a unlevered company as debt is cheaper than equity due to its tax advantage.

Raising equity finance increases the cost of capital, as once equity finance is raised the Weight of equity increases, thus the overall cost of capital increases.