Interview Question

Finance Manager TRACK Program Interview

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General Motors (GM)

Can your cost of debt ever be greater than your cost of equity?

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Disclaimer: The interviewer didn't like my answer. Technically your cost of debt can't be higher than your cost of equity because equity takes on more risk in case of bankruptcy because it falls in the back of the line. However, if you are too highly leveraged then your cost of debt would get pushed really high because of lower credit rankings, frightened suppliers, and other potential bankruptcy costs. This would push your cost of equity higher as well. Therefore, your cost of equity would still be higher than the cost of debt at that point but the increase in both was due to taking on too much debt. I would argue then that the cost of debt was higher than the cost of equity.

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I think while equity is riskier in the capital structure, the costs of debt and equity also depend on other factors like the credit perception of the company, the captial markets scenario, etc. Imagine a scenario where a company is heavily laden with debt, while stock markets and the economic environment are functioning well. The company will have very high cost of debt, while the cost of equity would be at its normal levels based on how much the market is expected to perform. Thus the cost of debt could be higher than cost of equity

Anonymous on

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