© 2000 John Petroff
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© 2000 John Petroff |
3)- Evidence on cost of debt lower than equity
a)- Historical evidence
In Chapter 2, Table T-2.1 showed that the rate of return on common stock of large corporations has averaged six percent more than the yield on corporate bonds. The premium for small company shares was even higher. It was also argued that, in normal circumstances of an upsloping yield curve, short term rates are lower than long term rates. For instance, yields on commercial paper have been at least one percentage point below long term corporate bonds. This confirms that there is a substantial saving in using debt compared to equity. The saving can be larger if the maturity of the debt is shorter, which is appropriate, naturally, only when financing working capital assets. Finally, using debt is also cheaper than financing with equity because the debt can be retired when the project it financed, is terminated, which would not be easily carried out for equity.
There have been times when long term yields where lower than short term yields (i.e. a downsloping yield curve). It would seem that increasing financial leverage during such periods would be wise. Actually, loanable money becomes extremely scarce, and long lived investments do not appear promising in the recessionary periods that often accompany downsloping yield curves.
See review questions Q-11B3.1 through Q-11B3.4.
See research assignments R-11B3.1 and R-11B3.2.
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