Comparative Analysis of debt and equity Debt is cheaper than equity But debt is

Comparative analysis of debt and equity debt is

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the dividend which is tax free in the hand of assesses. Comparative Analysis of debt and equity Debt is cheaper than equity. But debt is riskier than equity from company's perspective. As company issues debt, it has to accept the obligation of paying coupon and redemption price to the debt holder irrespective of the company’s financial health. In case of equity, dividend is payable only when company earns profit. Since there is no redemption price for equity, company has no financial obligation to its shareholders as such. Debt is less risky from investor’s perspective as it will receive coupon and
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6 redemption price irrespective of the profit or loss of the company. Equity is risky because dividend and capital appreciation will be enjoyed only when company earns profit. When company issues debt capital, it has to pay interest mandatorily to the debt holders irrespective of the fact whether the company earns profit or loss. The logic is simple cost of debt is cheaper than cost of equity. An illustration can be taken to explain the same. The company wants to pay 10% interest to debenture holder where face value of debenture is Rs 10. Similarly, the company wants to pay 10% dividend to equity share holder where face value of equity share is Rs 10. Corporate profit tax is 30% and dividend distribution tax is 20%. When company is paying interest to debt holder, company is eligible to enjoy the tax shield. The cost of debt is 0.1(1-0.3) =0.07. Alternatively, it can be stated that in order to pay 10% interest to the debenture holder, company has to earn effectively 7%. Dividend is the appropriation of profit. When company is earning profit, first company has to pay corporate profit tax .After that it may distribute certain portion of profit as dividend to the equity shareholders .In that case, company has to pay Dividend Distribution Tax(DDT).In order to pay dividend of 10% company is required to earn 0.1(1+0.2) =0.12 or 12% as 20% is DDT. Since corporate profit tax is 30% so company has to earn 0.12/(1-0.3) =0.1714 or 17.14 %Hence to pay 10% dividend , company has to earn 17.14%. This clearly shows equity is expensive than debt. Trading on Equity Generally, it is assumed high debt equity ratio is not good sign for a company. Too much dependence on debt sends negative signal to different stakeholders such as banks are not willing to sanction the loan, credit rating agencies provides adverse rating to the company and investors don’t not want put their hard earn money in the stock as a result likelihood is more the share of the company will underperform in secondary market. But there is another side of the coin also. In few cases, companies intentionally depend more and more on debt capital and it enhances their earning per share. This is known as trading on equity. If the return on capital employed of a company is greater than the cost of debt, the company can increase its EPS by depending excessively on debt capital. These phenomena can be explained by a simple illustration.
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