Question

What determines if the cost of debt is high or low? How does cost of equity depend on amount of leverage?

Answer 1

Cost of debt is dependent on the following macro-economic and micro-economic factors:

Macro Economic Factors:

1. Benchmark interest rates:

Most central banks across the world are given the responsibility to manage liquidity and inflation in the economy (generally). As a result, on a period basis, the Central Bank set "Repo and Reverse Repo" rates. These determine pricing of the Government Treasury securities which in turn determine the cost of lending funds by banks. Higher the benchmark rates, higher the lending rates.

2. Liquidity:

Liquidity often tends to skew bond prices. Risk averse investors tend to put their investment in bonds which will drive bond prices higher. This reduces the yield on Treasury Securities/bonds. The opposite is true in times of low liquidity. These risks also determine the Cost of lending to banks. Higher the liquidity, lower the benchmark rates, lower the lending rates.

3. Inflation:

Nominal rates tend to be high in times of high inflation to ensure that investors get a reasonable rate of "real returns". Higher the inflation, higher the interest rates. Lower the inflation, lower the interest rates.

Micro Economic Factors:

1. Credit Risk:

Higher the risk of default, higher will be the interest rates. Lower the risk of default, lower will be the interest rates. Credit risk is commonly measured through credit rating agencies such as Moodys, Fitch, S&P through Credit Ratings and Probabilities of Default.

2. Tenure:

Longer the period of the loan, higher will be the rate of interest. Shorter the period of the loan, lower will be the rate of interest. This is due to fact that the uncertainty over longer periods is higher resulting in higher risk.

Both point 1 and 2 are to compensate the lenders for bearing additional risks of lending.

Cost of Equity is also affected by the level of debt in the Balance Sheet. "Unlevered Balance Sheets" are those Companies where there is no debt.These Companies tend to be strong companies as they have adequate cash flow reserves to withstand any economic shock as well as liquidity crunches. Thus, the probability of these companies going into bankruptcy is generally lower. Hence, the risk being lower, the Cost of Equity will also be lower. However, contrary to this, in case a Company has a fair amount of debt, the chance that that Company will get into trouble is more likely than not. This makes it a riskier bet compared to unlevered companies. Hence, the cost of equity will be more to compensate the investors for bearing additional risks.