I was recently leading a seminar for CEOs and business owners, where a large number of participants could not understand why the cost of equity was so much higher than the cost of debt. I had mentioned that the cost of debt (eg. interest rates) were typically in the range of four percent to eight percent for most mid-sized companies in Central Europe, denominated in euros, and the cost of equity (eg. Internal Rate of Return) required by most private equity investors, was in the range of 25 percent or higher.

A number of seminar participants could simply not fathom why equity would cost four or five times as much as debt. As one of the seminar participants said, "I could understand if equity were 40, 50 or 60 percent more expensive than debt; I cannot understand why it might be four or five times as expensive". This article attempts to explain this phenomenon.

There are three major reasons:

• First of all, debt is typically secured by assets, whether real estate, machinery, receivables, inventory, or other things of value, which may be seized by the lender in case of default by the borrower. Equity ownership, by contrast, is not accompanied by any kind of security interest in the company financed by the equity holder. The equity holder cannot seize anything, the sole remedy of an equity holder generally being the right to vote at a shareholders' meeting. The aforementioned four to eight percent interest rate generally assumes that there is significant security for the lender. An unsecured loan would have a much higher interest rate, assuming a lender would be willing to lend on an unsecured basis - which is probably not the case.

• A second reason why the cost of equity is typically much higher than the cost of debt is that in the event of bankruptcy of a company, debt holders are satisfied in full before equity holders receive any proceeds of liquidation whatsoever. In other words, even an unsecured holder of debt will receive 100 percent of what is owed to him or her, before equity holders see a penny

• Thirdly, a company must pay holders of debt an interest rate, even if the company is loss-making (and failure to pay interest or to achieve debt coverage ratios may put the company into default and force a liquidation). Equity holders, by contrast, are paid dividends only to the extent that the company has been profitable, once all obligations in the ordinary course (eg. servicing of interest payments) have been satisfied.

So it boils down to a trade off between risk and reward. Debtholders have far lower risk (for the three aforementioned reasons). If a company is highly profitable, on the other hand, such profits or rewards will typically accrue to exclusively to the equity holders.

I once had a client, the CEO of a publicly owned telecom company, for whom we were carrying out a capital raising exercise, who kept insisting that he wanted to raise equity because equity was cheaper than debt.

It required a number of multi-hour sessions to understand his logic and convince him of the contrary. Essentially, he saw that his company had to pay debt holders huge amounts of interest every month, whereas equity holders only sporadically received relatively modest dividends. The company was still reinvesting cash generated from operations in an expansion program.

Raising additional equity would have had a dilutive effect on earnings of existing equity holders, as any private equity firm willing to invest equity would have demanded a percentage of equity which would have allowed them to achieve a minimum 25 percent Internal Rate of Return on their investment.

In short, the fact that equity is much more expensive than debt comes back to the principle that the higher the risk, the higher the expected rewards. And the risks associated with equity are significantly higher than the risks associated with debt.

Owners and managers of businesses always have the option of financing a business by way of either debt or equity. For any business, there is usually an optimal debt to equity ratio that best fulfils the objectives of owners and managers and which depends on a number of factors.

There are numerous advantages to financing via debt. Debt has the advantage of generally being tax deductible (although tax regimes in some countries do set a limit on the amount of debt which is deductible), and debt financing has the advantage of avoiding dilution of equity ownership. The cost of debt financing is therefore lower than the cost of equity.

However the big disadvantage of debt financing is that it increases the level of risk in the corporation (i.e. there is a higher risk of default). Moreover, as the level of debt increases in a company, the cost of such debt also tends to increase so as to compensate for the additional risk.

There are also a number of cyclical factors that may have an impact on the debt to equity ratio. The expected debt to equity ratio varies depending on whether markets are bullish or bearish, whether the economic sector to which a company belongs is more sunrise or sunset, or indeed whether a company is in an early development phase or at maturity.

During the last economic boom, most business owners would have preferred a higher mix of debt to equity as debt was readily available, interest rates were lower, companies had more accurate earnings forecasts, and earnings tended to rise over time. Expansion could be financed via debt, while existing equity owners remained in control and interest was tax deductible.

However, during the current recession, earnings are much more difficult to predict (companies often have trouble forecasting the coming quarter, let alone for the year) and debt is less readily available as a result of the much more conservative lending policies the banks are adopting. While interest rates such as Euribor, Libor, etc. have decreased by several percentage points, the spreads over Euribor or Libor have generally increased by anywhere from 100 to 400 basis points for most companies, meaning that the real cost of debt financing (after adjustment for inflation) has generally increased.

The word ‘deleveraging’ often arises during the current recession. The dynamics described above often force companies to substitute equity for debt. However, equity has also become more difficult and costly to source compared to 18 months ago. Despite this, beefing up the balance sheet with a healthy dose of equity is an option that the majority of business owners and managers should be considering today.

In addition to the option of equity injection, hybrid instruments (which contain features of both debt and equity) may also strengthen a company’s financial position. Two common hybrid instruments are preferred shares (which have an obligation to pay a certain dividend rate) and convertible debt (where the lender may be willing to accept a lower interest rate in exchange for having the option to convert the debt into equity at a later date). Hybrid instruments typically have a level of risk that is higher than debt but lower than equity, and therefore the cost of financing also lies somewhere between the cost of debt and the cost of equity. (Hybrid instruments will be the subject of subsequent columns).

A strong balance sheet can be even more of a source of strength and competitiveness in a recession than during a boom. It is no accident that even strong banks such as HSBC are raising equity, not because they are undercapitalized, but to take advantage of opportunities in the marketplace. Equity may also be viewed as a financial cushion, something that could help companies weather a deepening recession in the event that the much-touted recovery does not occur as soon as expected.