Why Is Cost of Equity Higher Than Cost of Debt?

Companies require capital to fund their operations, growth, and investments. This capital comes from debt financing (borrowing money) or equity financing (issuing ownership shares). Both methods come with a cost, representing the return required by capital providers.

The cost of equity is the return a company must offer shareholders to compensate them for the risk of holding its stock. Conversely, the cost of debt is the interest rate a company pays lenders for borrowed funds. The cost of equity is generally higher than the cost of debt for a business.

Understanding Risk and Return

The cost of different capital sources is governed by the direct relationship between risk and required return. Investors demand a higher expected return for taking on greater risk. Equity investments inherently carry more risk for investors compared to debt investments.

Equity holders are residual claimants, meaning their returns are not guaranteed. Their returns are contingent upon the company’s profitability and future growth. Shareholders anticipate capital appreciation or dividends, but neither outcome is assured. This uncertainty means equity investors face a higher degree of risk.

Debt holders, by contrast, receive fixed interest payments at predetermined intervals and the repayment of their principal. These cash flows are more predictable and less volatile than those associated with equity. While debt holders face credit risk, their position is more secure than equity holders. The higher risk borne by equity investors translates into a higher required rate of return, which becomes a higher cost for the company to raise equity capital.

The Impact of Priority Claims

The priority of claims during financial distress or liquidation is another factor contributing to the higher cost of equity. Debt holders possess a legal claim on the company’s assets and earnings that takes precedence over equity holders. If a company goes bankrupt and its assets are sold, debt holders are paid first from the proceeds.

Many debt instruments, particularly secured loans, grant lenders specific claims on company assets as collateral. This secured position further reduces the risk for lenders.

Equity holders are last in line to receive any distribution from the company’s assets during liquidation. They receive funds only after all creditors, including debt holders, have been fully satisfied. This “residual claim” status significantly increases the risk for equity investors, as there may be little to no assets remaining, potentially leading to a complete loss of their investment. This junior claim justifies their demand for a higher return, contributing to a higher cost of equity for the company.

Tax Advantages of Debt Financing

A distinct reason for the cost differential between debt and equity lies in the tax treatment of interest payments on debt. Interest expense incurred on borrowed funds is generally tax-deductible for corporations in the United States. This means interest payments reduce a company’s taxable income, lowering its overall corporate income tax liability.

This tax deductibility effectively reduces a company’s tax burden. This tax shield effectively lowers the net, or after-tax, cost of debt for the company. The actual cost of the debt is less than the stated interest rate because a portion of the payment is offset by tax savings.

In contrast, dividends paid to equity holders are not tax-deductible for the company. Dividends are distributed from a company’s after-tax profits, meaning the company has already paid corporate income tax on the earnings. This lack of a tax shield for equity financing makes it comparatively more expensive on an after-tax basis than debt financing, which benefits from interest deductibility. The tax advantage contributes to making debt a cheaper source of capital for companies.

Market Perception and Volatility

Market perception and the inherent volatility of financial instruments also play a role in the cost differential. Stock prices are more volatile and sensitive to factors like market sentiment, economic conditions, and company performance announcements. This greater fluctuation means equity investors face more uncertainty regarding their investment’s value.

This inherent volatility demands a higher premium from equity investors to compensate for the increased risk of price swings. Investors require a higher expected return from equity investments to offset potential losses due to market fluctuations. The perception of higher risk in the equity market directly translates to a higher required rate of return.

Debt returns, particularly for highly-rated companies, tend to be more stable and predictable. The contractual nature of interest payments and principal repayment provides a degree of stability not found in equity. The combined effect of higher inherent risk, subordinate claims, lack of tax advantages, and greater market volatility makes equity a more expensive source of capital for companies than debt.