Lesson 3 of 6 · 14 min
What drives the costs of debt and equity
Investors price debt and equity from the same cash flows, so the costs of both rise and fall together with market conditions, industry exposure and the issuer's own sales risk, operating leverage, financial leverage and collateral.
In short
- Costs of debt and equity tend to move together: both are claims on the same cash flows and respond to the same risks.
- Top-down: economic conditions (growth, inflation, monetary policy, FX) move government rates and credit spreads; cyclical sectors feel it most. Industry exposure matters (oil price: good for producers, bad for airlines).
- Firms ideally borrow when rates and spreads are low and issue equity when share prices are high.
- Issuer-specific: (1) sales risk, (2) operating leverage = fixed costs ÷ total costs, (3) financial leverage and interest coverage = EBIT ÷ interest, (4) collateral and asset type.
- Higher operating or financial leverage magnifies swings in profit and ROE, raising required returns.
- Operating leverage = sensitivity of EBIT to revenue; financial leverage = sensitivity of net income to EBIT; total leverage = both combined.
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