Capital Markets, Debt and Equity Financing
Long-term financing is raised through debt (bonds, sukuk, term finance certificates, syndicated loans) or equity (initial public offering, rights issue, private placement). The exam tests capital structure reasoning, the cost of each source, and whether you can rank financing options on after-tax, risk-adjusted terms rather than headline coupon.
The two routes
Debt gives a tax shield because interest is deductible, but adds fixed obligations, covenants and refinancing risk. Equity has no mandatory payment but dilutes control and existing shareholders, and its cost is higher because investors bear residual risk. Issuance requires disclosure, valuation and - for a listing - compliance with exchange requirements on free float, track record and governance. Sukuk must be asset-backed and Shariah-compliant in structure, so they cannot simply replicate a conventional coupon.
Worked example
A firm needs 5bn: 2bn debt at 11% pre-tax and 3bn equity. The tax rate is 29%, so after-tax cost of debt = 11% × (1 − 0.29) = 7.81%. Cost of equity is estimated with CAPM: risk-free 10%, beta 1.1, equity risk premium 6%, so Ke = 10% + 1.1 × 6% = 16.6%. WACC = 0.4 × 7.81% + 0.6 × 16.6% = 3.12% + 9.96% = 13.08%. A project funded this way must clear 13.08% after tax to create value; anything below that destroys it regardless of how attractive the coupon looks.
Traps that cost marks
Using the pre-tax cost of debt in WACC; weighting with book rather than market values; ignoring issuance fees and underpricing; assuming more debt is always cheaper without repricing the equity and the credit spread; comparing a bond yield with an equity return without adjusting for risk; overlooking dilution and covenant headroom.