Why Is the Cost of Debt Cheaper Than Equity?

The cost of debt and the cost of equity represent the returns that investors expect for providing capital to a company. The cost of debt is essentially the effective interest rate a company pays on its borrowed funds, such as loans and bonds. This cost includes interest payments and any associated fees. Conversely, the cost of equity is the return that a company aims to provide its equity investors, or shareholders, to compensate them for the risk they undertake by investing their capital. Understanding these costs is fundamental for businesses when making financing decisions, as debt is generally considered a more affordable source of capital than equity.

Why Debt is Less Risky for Investors

Debt is less risky for investors than equity, which influences its lower cost for companies. Debt holders, such as banks or bond investors, receive specific legal protections that reduce their potential for loss. In the event of liquidation or bankruptcy, debt holders have a higher claim on company assets and earnings. They are legally entitled to be paid back before equity holders receive any distribution. This priority in payment significantly lowers the risk for lenders.

Debt instruments involve fixed interest payments, providing lenders a predictable income stream. This predictability contrasts sharply with the variable nature of equity returns, which depend on company performance. Corporate debt is often secured by specific company assets, such as real estate, equipment, or accounts receivable. If the company defaults, the lender can seize and sell collateral to recover funds, providing security.

Lending agreements also frequently include debt covenants, which are contractual terms designed to protect the lender’s interests. These covenants can be affirmative, requiring the borrower to maintain certain financial ratios or provide audited statements, or negative, restricting actions like taking on excessive additional debt or paying out large dividends. By agreeing to these conditions, companies can obtain loans with more favorable terms, reflecting the reduced risk for the lender. These risk-mitigating factors lead debt investors to accept a lower expected rate of return, which translates into a lower borrowing cost for the company.

Why Equity is More Risky for Investors

Equity investors face higher risk than debt holders, necessitating a higher expected return and cost for the company. Equity holders are residual claimants, paid last in financial distress or liquidation. All other creditors, including debt holders, must be satisfied before shareholders receive any funds. This position exposes equity investors to the greatest potential for loss.

Returns on equity, such as dividends and capital gains, are not guaranteed and fluctuate based on the company’s profitability and overall market performance. Unlike the fixed interest payments of debt, a company is not obligated to pay dividends, and their distribution depends on management decisions and financial health. This inherent variability means equity investors bear the full uncertainty of the company’s future earnings and growth prospects.

Equity investments are not secured by company assets. There is no specific collateral that equity investors can claim if the company performs poorly or goes bankrupt, unlike with secured debt. This absence of collateral further elevates the risk for shareholders. The value of an equity investment is directly tied to the inherent uncertainty of a company’s future performance and the broader economic environment.

Due to these elevated risks, equity investors demand a higher expected return to compensate for uncertainty and potential loss. This higher demanded return is the company’s cost of equity, making it a more expensive form of financing than debt. The compensation sought by shareholders accounts for the greater volatility and lack of guaranteed returns associated with owning a piece of a company.

The Tax Advantage of Debt Financing

A significant factor in debt’s lower effective cost is the tax deductibility of interest payments. Interest paid on debt is a tax-deductible expense for a company. This reduces the company’s taxable income, lowering its tax liability. This reduction in taxes is often referred to as a “tax shield.”

For example, if a company pays $100,000 in interest and faces a federal corporate tax rate of 21%, which is the flat rate in the United States, that $100,000 reduces the income subject to this tax. The company effectively saves $21,000 in taxes (21% of $100,000). This tax savings means the actual cash outflow for the interest payment is less than the stated interest rate. The after-tax cost of debt is calculated by multiplying the pre-tax interest rate by (1 minus the corporate tax rate).

This tax shield reduces the net cost of debt for the company, making it more financially appealing. Without this deduction, the cost of debt would be higher. In contrast, dividend payments to equity holders are not tax-deductible for the company. A company pays taxes on its profits first, then distributes after-tax profits as dividends. This difference highlights why debt financing is more cost-effective, providing a direct tax benefit that equity does not.