Debt and Equity

Businesses often require capital to operate successfully, and this capital has numerous
sources. The primary sources of capital are debt and equity, which provide the necessary funding
needed to keep a business afloat. One of the sources of capital is the cost of debt, which refers to
borrowed funds that have to be repaid at a later date. The other source of capital is equity, which
often comes from funds invested by shareholders. There are specific differences between the cost
of debt and the cost of equity. One of the differences is that in the cost of equity, there is no
interest involved, and thus it is not tax deductible (Shen & Zhang, 2020). On the other hand, the
cost of debt is associated with interest payments. The other difference is that cost of equity is the
rate of return that shareholders expect for their investments, while the cost of debt is the rate of
return dictated by bondholders for their investments.
A critical examination of the real risk-free rate and nominal risk-free rate indicates that
they have specific differences. The first difference is that the real risk-free rate takes into account
the inflation rates when determining interest rates. In contrast, the nominal risk-free rate is the
interest rate determined before taking inflation into account. It is vital to acknowledge that
inflation directly impacts the real risk-free rate, which is normally called the Fisher effect
(Kozlovsky et al., 2020). Notably, nominal risk-free rates are usually advertised by banks and
investment providers for bonds and loans. A real risk-free rate is used to assign value to assets
because it puts into consideration inflation, which directly affects the value of assets. Inflation
can either reduce or increase the value of assets and thus should be incorporated in determining
the actual value of assets.

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References

Kozlovsky, A., Bilenko, D., Kozlovskyi, S., Lavrov, R., Skydan, O., & Ivanyuta, N. (2020,
September). Determination of the risk-free rate of return on an investment efficiency
based on the fractal markets hypothesis. In Forum Scientiae Oeconomia (Vol. 8, No. 3,
pp. 61-72).
Shen, C. H. H., & Zhang, H. (2020). What’s good for you is good for me: The effect of CEO
inside debt on the cost of equity. Journal of Corporate Finance, 64, 101699.