Question

Define capital, debt, and equity. Discuss 3 important differences between the two types of capital. Which is riskier and why? (maximum 350 words)

Answer 1

Capital refers to the financial resources businesses may use to finance their operations, such as cash, machinery, equipment, and other resources. These are the assets that allow the company to deliver a product or service for sale to clients.

Debt is a sum of money one party borrows from another. Debt is used by many companies and individuals as a means of making major transactions that, under normal circumstances, they could not afford. A loan contract provides permission to borrow money to the investing party on the condition that it is repaid back at a later date, usually with interest.

Equity is the value that can be assigned to a business's owners. It reflects the amount of money that would be returned to shareholders of a corporation if all the properties had been liquidated and all the company's debt paid off.

The two types of capital are Equity Capital and Debt Capital. Three major differences are:

1. The equity investors are business owners; the debt investors are business lenders.

2. Equity investors benefit from no fixed return, debt investors receive a pre-decided interest rate.

3. Equity capital is for perpetuity rather than redemption, debt capital must be returned after a specified period of time.

Debt raise is cheaper but equity is more expensive than debt. Debt is riskfree because, unlike in equity, they're no risk-return trade-off. Debt investors do not suffer market volatility, but Equity investors could. CAPM model is used for raising Equity cost of capital where beta risk is included and another way is, bond yield plus risk premium method where risk is inherent as well. But the cost of debt Kd, there is no risk involved but it is the contractual cash payable equal to its issue proceeds. At the same time, Ki, the term-loan costs to raise is nothing but Interest multiplied by post-tax rate and one can avail tax exemption from it, hence it is safer.