Is Debt or Equity Financing More Expensive?

Businesses seeking capital must decide between borrowing money through debt or selling ownership stakes through equity. Debt financing involves loans or bonds that must be repaid with interest, while equity financing brings in new owners who provide capital for a share of future profits. This choice is a strategic decision that impacts a company’s balance sheet, tax obligations, and control structure. Understanding the true cost associated with each option is the first step in making an informed choice that aligns with the company’s long-term goals.

Calculating the Cost of Debt

The most apparent cost of debt financing is the interest rate, which can be fixed or variable. In addition to interest, debt often comes with other explicit costs, such as origination fees, closing costs, or annual service fees. These fees can range from a fraction of a percent to several percentage points of the total loan amount and should be factored in to understand the total upfront expense.

A feature of debt financing is the tax-deductibility of interest payments, which creates a tax shield. While federal regulations can limit this deduction for larger companies, this limitation does not apply for most small businesses with average annual gross receipts under $31 million. For companies that can take the full deduction, the tax shield lowers their taxable income and overall tax liability, reducing the true cost of the debt.

To illustrate, consider a company with a $100,000 loan at a 6% interest rate and a corporate tax rate of 21%. The annual interest expense is $6,000. Because this interest is tax-deductible, the company’s taxable income is reduced by $6,000, resulting in a tax saving of $1,260 ($6,000 x 21%). The after-tax cost of the debt is therefore not $6,000, but $4,740, which translates to an effective interest rate of just 4.74%.

Debt financing can also introduce non-monetary obligations. Lenders often impose debt covenants, which are restrictions or requirements the borrower must adhere to. These can include maintaining certain financial ratios, limiting additional borrowing, or prohibiting major asset sales without permission. These covenants can constrain management’s flexibility and require regular, detailed financial reporting.

Determining the Cost of Equity

Unlike debt, the cost of equity financing is not a simple interest rate. It is an implicit, or opportunity, cost represented by the return that equity investors demand for taking on the risk of ownership. Since shareholders are last in line to be paid in a business failure—after all lenders and creditors are satisfied—they assume a higher risk and expect a higher potential return.

This required rate of return is the “cost” of equity. While there is no explicit payment like interest, the company must generate profits sufficient to meet these investor expectations. If it fails to do so, the value of its stock may decline, and attracting future investment can become more difficult. This expected return for equity investors is higher than the interest rate a company would pay on a loan.

Another cost of equity is the dilution of ownership for the existing owners. When a company issues new shares, the original owners’ stake in the business is reduced. For example, if a founder owns 100% of a company and sells a 25% stake to an investor, their ownership drops to 75%. This dilutes their claim on future profits and diminishes their voting power.

For companies that pursue public offerings, there are also direct costs associated with issuing equity. These include underwriting fees paid to investment banks, which can range from 3% to 7% of the capital raised, as well as legal, accounting, and registration fees. The ongoing costs of being a public company, such as regulatory compliance and shareholder reporting, also add to the financial burden.

A Direct Comparison of Financing Costs

When directly comparing the two methods, equity is more expensive than debt from a pure percentage standpoint. The required rate of return for equity investors, who bear the highest risk, surpasses the interest rates demanded by lenders. This difference in risk and expected return is the driver of the cost disparity.

The tax treatment of each financing type widens this gap. Interest payments on debt are tax-deductible, lowering the effective cost for the company. In contrast, dividends paid to shareholders are not tax-deductible because they are distributed from after-tax profits.

This cost advantage for debt is balanced by different risks. The non-financial cost of equity is the permanent dilution of ownership and control. Conversely, the risk of debt financing is the threat of bankruptcy, as the obligation to make fixed payments is legally binding regardless of performance. A business downturn could lead to a default and potential insolvency.

Key Factors That Influence Capital Costs

The cost of securing either debt or equity is not static; it is influenced by a company’s specific circumstances and the economic environment. A company’s stage of development and size play a role. A mature, profitable corporation with stable cash flows is seen as low-risk and can access debt financing at competitive interest rates. Conversely, an early-stage startup with no revenue history may find debt financing unavailable and must rely on equity, which is more expensive due to high investor risk.

Prevailing economic conditions are another determinant. The interest rate environment, shaped by central bank policies, directly impacts the cost of new debt. When benchmark rates are low, companies can borrow more cheaply. In times of high inflation or economic uncertainty, lenders may demand higher interest rates to compensate for increased risk.

A company’s individual performance and risk profile are also important. Strong profitability, consistent cash flow, and a solid credit history will lower the perceived risk for lenders, resulting in a lower cost of debt. Similarly, investors will demand a lower rate of return from a financially healthy company in a stable industry. High industry risk or volatile earnings will increase the required return for both debt and equity providers.

The Concept of an Optimal Capital Structure

The goal for a business is not simply to find the cheapest single source of funding, but to determine the ideal mix of debt and equity. This blend is known as the company’s capital structure, and the blended cost of all its financing is called the Weighted Average Cost of Capital (WACC). The objective is to find the specific mix that results in the lowest possible WACC, which in turn maximizes the company’s market value.

There is a trade-off involved in this balancing act. Initially, adding some low-cost, tax-advantaged debt to the capital structure can lower the overall WACC. A company financed entirely by equity is likely not minimizing its cost of capital because it is forgoing the benefits of cheaper debt.

However, as a company takes on more debt, its financial risk increases. The burden of higher fixed interest payments makes earnings more volatile and raises the probability of bankruptcy. This increased risk will eventually cause both lenders and equity investors to demand higher returns. Consequently, a point is reached where adding more debt starts to increase the WACC, reducing the firm’s value. This is why companies strive for a balanced, or optimal, capital structure.