Is the Cost of Debt or Equity Higher?

Businesses require funding to operate, expand, and innovate. This funding, known as capital, comes with an associated cost. Understanding the cost of capital is important for companies to make sound financial decisions and for investors to evaluate a company’s financial health. Capital primarily originates from two sources: debt and equity; debt involves borrowing funds, while equity represents ownership stakes. Both sources incur a cost for their use, and this article will explain these costs and clarify which form of capital is typically more expensive.

Defining the Cost of Debt

The cost of debt is the interest rate a company pays on borrowed money, such as loans or bonds. For example, a company borrowing $1 million at 5% annual interest would have a yearly expense of $50,000. This payment is a contractual obligation, due regardless of profitability.

Interest payments on debt are tax-deductible for businesses in the United States, reducing their taxable income and overall tax liability. This tax benefit effectively lowers the net cost of debt. For instance, a $50,000 interest payment at a 21% corporate tax rate saves $10,500 in taxes, reducing the actual after-tax cost.

Factors influencing a company’s cost of debt include:
Prevailing market interest rates, which set the baseline for borrowing costs.
The company’s creditworthiness, impacting the interest rate offered by lenders.
Financial health and payment history, as strong companies secure lower rates.
Specific loan terms, such as collateral, with secured loans often carrying lower rates.

Defining the Cost of Equity

Unlike debt, equity does not involve fixed interest payments or a principal repayment date. The cost of equity represents the return that equity investors expect for their investment. This expected return compensates them for providing capital and assuming ownership risks. It is a theoretical cost, reflecting the opportunity cost of investing in one company versus another with similar risk.

The cost of equity is not a direct outflow like interest payments, but an implicit requirement to attract and retain investors. Failure to meet investor expectations can lead to stock price decline and difficulty raising capital. This expected return must cover the time value of money and account for inherent business ownership risks.

Factors influencing the cost of equity include overall stock market risk, which impacts expected returns across all equities. A company’s specific business risk, such as industry volatility, competitive landscape, and operational stability, is also a factor.

A company’s growth prospects and dividend policies influence investor expectations. Companies with strong growth potential or consistent dividends may command a lower expected return. The cost of equity is the minimum return a company must generate on equity-financed investments to satisfy shareholders and maintain market valuation.

Why Equity is Generally Costlier

Equity is more expensive than debt due to the difference in investor risk. Debt holders have a senior claim on a company’s assets and income. In bankruptcy or liquidation, debt holders are repaid before equity holders. This seniority significantly reduces risk for debt investors, allowing companies to borrow at lower interest rates.

Equity investors are residual claimants, receiving a return only after all other obligations are satisfied. This means equity holders bear the full variability of company performance and face a higher risk of losing their investment if the business performs poorly or fails. To compensate for this elevated risk, equity investors demand a higher expected rate of return.

Another reason for the higher cost of equity is the tax treatment of interest versus dividends. Interest payments on debt are tax-deductible, reducing the effective cost of debt. Dividends paid to equity shareholders are distributions of after-tax profits and are not tax-deductible. This lack of a tax benefit for equity increases its relative cost compared to debt.

Equity represents a permanent investment with no fixed maturity date, unlike debt which has a repayment schedule. Debt must eventually be repaid or refinanced, while equity remains indefinitely. The permanence of equity, combined with its higher risk and lack of tax deductibility, contributes to its higher cost for a business.

Nuances in Cost Comparison

While equity is costlier, debt can be prohibitively expensive in specific situations. High-risk borrowers, like startups or financially distressed companies, may face extremely high interest rates. Lenders demand substantial compensation for elevated default risk, potentially making debt more expensive than equity in these niche cases. In these scenarios, the perceived risk of lending might push interest rates to levels that outweigh even the high expected returns of equity investors.

Beyond the interest rate, debt can impose non-monetary costs through restrictive covenants. Lenders often include clauses in loan agreements that limit a company’s operations, such as restrictions on additional debt or dividend payments. These covenants, while protecting the lender, can limit a company’s operational flexibility and strategic decision-making, representing an indirect but tangible cost of debt.

Excessive reliance on debt can lead to significant financial distress costs. If a company takes on too much debt, the increased risk of bankruptcy can trigger negative consequences. These include legal and administrative fees associated with insolvency, loss of customer and supplier confidence, and difficulty attracting and retaining talent. These indirect costs, while not part of the direct interest expense, represent a real economic burden that can arise from an imprudent debt structure, making the overall cost of debt much higher than initially perceived.