Why Is Debt Cheaper Than Equity?

Businesses require funding to operate and expand, sourcing capital through debt or equity. Debt financing involves borrowing money, obligating the company to repay the principal with interest. In contrast, equity financing entails selling ownership stakes to investors. Each method has an associated cost reflecting the return expected by capital providers. This difference often positions debt as a comparatively cheaper source of capital than equity for a business.

Understanding the Cost of Debt

The cost of debt financing is the interest expense paid on borrowed funds. For corporations, interest payments are generally tax-deductible. This deductibility reduces a company’s taxable income, lowering its tax liability. This reduction, known as a “tax shield,” effectively reduces the net cost of debt. For example, if a company pays $1 million in interest and is subject to a 21% corporate tax rate, the tax shield provides a savings of $210,000, making the after-tax cost $790,000.

Several factors influence the interest rate a company pays. A company’s creditworthiness, often reflected in its credit rating, significantly impacts borrowing costs, with higher ratings leading to lower interest rates due to reduced default risk. Prevailing market interest rates, influenced by broader economic conditions and inflation, also play a substantial role. Additionally, loan terms like maturity period, collateral, and the overall economic outlook can affect the negotiated interest rate.

Understanding the Cost of Equity

The cost of equity arises from the returns equity investors expect. Unlike debt, there is no fixed interest payment; shareholders anticipate returns through dividends, capital appreciation, or both. These expected returns compensate investors for the risk they undertake. Dividends paid to shareholders are generally not tax-deductible for the company, meaning the full dividend payment represents a direct cost.

Equity investors demand a higher rate of return than lenders because their investment carries greater risk. In liquidation or bankruptcy, debt holders have a prioritized claim on assets, paid before equity holders. This junior position, coupled with stock market volatility, leads equity investors to demand an “equity risk premium”—an additional return beyond a risk-free rate to compensate for heightened risk. This higher required return translates into a higher cost of equity.

Factors influencing the cost of equity include overall market volatility, which increases the perceived risk of investing. A company’s growth prospects and industry risks also shape investor expectations. General economic conditions and the prevailing risk-free rate, often benchmarked against long-term government bonds, contribute to determining the base return investors expect.

Factors Influencing Capital Structure Decisions

While debt appears cheaper due to tax deductibility, companies must consider its financial risk. Excessive debt increases financial risk, raising the possibility of default or bankruptcy. Maintaining a balanced capital structure mitigates this risk, ensuring the company can service its obligations.

Issuing new equity avoids debt burdens but introduces control and ownership dilution. Issuing additional shares decreases existing shareholders’ ownership and voting power. This dilution concerns founders and early investors who wish to maintain control.

A company’s capital structure also affects its flexibility and ability to secure future financing. High existing debt makes it more challenging and expensive to borrow, as lenders view the company as higher risk. Conversely, a reasonable debt-to-equity balance signals financial health, making capital easier to access.

Industry norms shape capital structure decisions. Capital-intensive industries, like utilities or manufacturing, frequently use more debt due to substantial asset investments. Technology or service-based companies may rely more on equity. A company’s stage of development also matters; startups often depend on equity from venture capitalists, while mature companies find debt more accessible and cost-effective. Market conditions, including investor sentiment and capital availability, further influence the attractiveness and cost of debt and equity.

Combining and Comparing Capital Costs

Companies evaluate their overall financing expenses using the Weighted Average Cost of Capital (WACC). WACC represents the average rate of return a company expects to pay to all its investors, considering the proportional mix of its debt and equity financing. This calculation blends the after-tax cost of debt with the cost of equity, weighted by their respective proportions in the capital structure.

A lower WACC indicates a company can finance its operations and investments at a reduced cost. This makes WACC a valuable tool for investment decision-making, serving as a “hurdle rate” that projects must exceed to be financially viable. Projects with expected returns higher than the WACC are viewed as value-adding opportunities.

The tax deductibility of interest payments on debt plays a significant role in making debt a cheaper component of WACC. Because interest reduces taxable income, the effective cost of debt is lowered, which in turn reduces the overall WACC. This, combined with the lower risk premium demanded by lenders compared to equity investors, solidifies debt’s position as the less expensive source of capital for a business.