Why Is the Cost of Equity Higher Than Debt?

Companies rely on various sources to finance their operations and growth initiatives. The “cost of capital” represents the return a company must provide to attract and compensate these providers of funds, whether they are lenders or investors. Understanding these costs is important for strategic financial decisions, and it is generally observed that the cost of equity financing is higher than the cost associated with debt.

Understanding Cost of Equity and Cost of Debt

The cost of equity refers to the return a company must generate to satisfy its equity investors, or shareholders. This expected return encompasses both dividends paid out and any appreciation in the stock’s value over time. It represents the compensation shareholders demand for providing capital to the company, making it the company’s cost of utilizing shareholder funds.

Conversely, the cost of debt is the effective interest rate a company pays on its borrowed funds. This includes the interest payments made on loans, bonds, or other credit facilities. It reflects the compensation lenders require for providing capital, and it is the company’s expense for using borrowed money.

Investor Risk and Claim Priority

Equity investors generally bear a higher level of risk compared to debt holders. Their returns are not guaranteed, as dividend payments can fluctuate or be suspended, and the stock price can decline based on market conditions and company performance. Equity investments are directly tied to the company’s success, meaning shareholders face the full impact of operational and financial uncertainties. This elevated risk demands a higher expected return to compensate investors for the potential loss of their capital.

Debt holders face less risk. They have a contractual right to receive regular interest payments and the return of their principal amount by a specified maturity date. Many debt instruments are also secured by specific company assets, providing a layer of protection for lenders. This contractual certainty and potential collateral reduce the overall risk for debt investors, leading them to accept lower returns.

A significant factor contributing to the difference in cost is the “priority of claims” in the event of a company’s financial distress or bankruptcy. In such scenarios, debt holders have a superior claim on the company’s assets compared to equity holders. Secured creditors are paid first from the proceeds of liquidated assets, followed by unsecured creditors. Common stockholders are last in line, meaning they often receive little to no recovery if the company’s assets are insufficient to cover its liabilities.

Corporate Tax Benefits

Another reason for the lower cost of debt stems from the tax treatment of interest expenses. Interest payments on corporate debt are tax-deductible for companies. This means that interest expense reduces a company’s taxable income, effectively lowering its overall corporate income tax liability.

In contrast, dividend payments made to equity holders are not tax-deductible for the company. These payments are distributed from a company’s after-tax profits. This difference in tax treatment provides a substantial advantage for debt financing, making its effective cost to the company lower than that of equity.