A. Why is debt a comparatively cheaper form of finance than equity? Debt involves borrowing money that is to be repaid over a period of time, usually with interest. Debt can be either short-term requiring payment in less than one year or long-term involving payment in one year or more. Equity financing involves the exchange of money for an ownership interest in a business. Equity financing is an investment, not a form of debt. The interest rate on debt is often a fixed rate. The return required by equity holders is not fixed. This means that in return for sharing the risks, equity investors expect to share in the profits and the more profits a company makes the more equity investors expect to receive in the form of dividends. Thus, one of the reasons that debt is a less expensive form of financing that equity involves the fact that the interest on debt is known and fixed or at least finite, while the expectations of equity investors is not limited by any specific contractual requirements or agreements relating to the return the will receive on their investment.
B. If debt is cheaper than equity, why do companies approach the equity markets? Many companies require infusions of capital in the form of both debt and equity in order to raise the funds necessary to fund or to expand the business. Debt and equity financing are not mutually exclusive, and there are advantages and disadvantages to both. For example, debt repayments must occur whether the company is profitable or unprofitable. Debt tends to be more of a short term form of financing while equity can be considered a source of long term cash. For most companies, the key is to find the right blend between debt and equity financing.
C. Can one minimize WACC when there is a constraint on raising debt? If so, how? The WACC is the average cost of capital invested in the business which is weighted by the portions that are bonds and any other form of long term debt, Preferr...