Why Is Debt Financing Cheaper Than Equity?

Businesses require capital to operate and grow, often raising funds through two primary methods: debt financing and equity financing. Debt financing involves borrowing money that must be repaid, typically with interest, while equity financing involves selling ownership stakes in the company. Debt is frequently considered a less expensive way for companies to secure capital compared to equity. This cost difference stems from fundamental distinctions in their structure and treatment.

The Direct Cost of Debt

The direct cost of debt consists primarily of explicit interest payments to lenders. Lenders include banks (term loans, lines of credit) or bondholders (corporate bonds). The interest rate is the price paid for borrowed money and a contractual obligation.

Interest rates are influenced by prevailing market rates and economic conditions. A company’s creditworthiness, including financial stability and repayment history, also impacts the rate. Loan term can also affect the interest rate. This interest payment is a fixed expense, regardless of the company’s profitability, and forms the nominal cost of borrowing.

The Direct Cost of Equity

Unlike debt, equity financing does not involve fixed interest payments or a maturity date for repayment. The direct cost of equity represents the return that shareholders expect to earn on their investment. This expected return encompasses dividend payments and potential capital appreciation (stock price increase). Companies must generate sufficient returns to attract and retain equity capital.

This implicit cost is not a contractual rate like interest on debt, but derived from what investors demand for assuming ownership risk. Equity investors contribute capital with the expectation of sharing in the company’s future profits and growth. If a company fails to deliver expected returns, it may struggle to raise additional equity or see its stock price decline. Therefore, the cost of equity reflects the company’s need to generate profits that satisfy its owners.

Tax Deductibility of Interest

A primary reason debt financing is cheaper than equity is the tax deductibility of interest payments. For corporations, interest paid on debt is a deductible business expense, reducing taxable income. This lowers its corporate income tax liability. This “tax shield” effectively shelters income from taxation.

For example, $100,000 in interest on $1,000,000 taxable income reduces taxable income to $900,000. Tax savings directly lower the net cost of debt. This makes the after-tax cost of debt lower than its stated interest rate.

In contrast, dividends paid to equity shareholders are distributed from a company’s after-tax profits. The company has already paid corporate income tax on earnings before distributing to shareholders. Therefore, dividends do not provide a tax shield, making equity a more expensive financing option from a corporate tax perspective. The absence of this tax deduction for equity payments contributes to the cost differential between debt and equity.

Risk Profile and Investor Returns

The difference in risk between debt and equity investors influences their required returns, impacting a company’s cost of capital. Debt holders (creditors) typically have a senior claim on a company’s assets and earnings. In financial distress or liquidation, debt holders are repaid before equity holders. Their returns are usually fixed, consisting of regular interest payments.

Because debt holders face lower risk, they demand a lower return. This is due to their prioritized claim on assets and income, and contractual interest payments. They are less exposed to operational and market risks impacting profitability.

Conversely, equity holders are residual claimants, receiving what remains after all other obligations, including debt, are satisfied. They bear the primary business risk, with returns tied to company performance and profitability. Due to this higher inherent risk, equity investors demand a higher expected return to compensate for uncertainty and potential loss. This “risk premium” makes equity a more expensive capital source, as the company must generate higher returns to satisfy shareholders.