Why is debt a comparatively cheaper form of financing than equity?

Answer 1

Because debt is a fixed amount that can be repaid, with the owners of the business retaining full ownership after repayment. Equity makes one an owner of a (presumably) growing business and therefore of potentially huge value and an indeterminate loss to the original owners.

AnswerI am not sure I would agree with the above and it seems circular at best (although perhaps it's trying to address the dilution of value to existing stock holders when more stock is issued)- but the common answer is because of the tax effect difference between dividends and interest.

Historically, Business Finance considers debt less expensive than equity because the payments on debt - interest - are before earnings and receive a tax deduction as a business expense. Whereas, dividends, which are how you pay equity financing, are not tax deductible and are paid from after tax earnings.

So, in a 35% tax rate (the current federal corp tax rate), paying $100 of interest has the same cost to the company as paying $65 of dividends. Adding the effect of State taxes, etc. even increases the effect.

Paying the same of in dividends, the amount paid gets no tax benefit and has a real cost of the $100. So, you can carry much more debt for the same net cost as using the dividend/equity option.

Finally, debt (credit line or bonds) can be easily replaced and refinanced should interest rates fall, or the company has a credit rating improvement. Equity, once in place, is there to stay.

AnswerIn addition to the above. Debt is cheaper than equity because providers of debt are exposed to less risks than providers of equity (shareholders). This is because (1) interest needs to be paid out regardless of net income, while dividends can only be paid when the firm has been profitable, and, (2) in case of bankrupcy, debt providers have priority over shareholders.

Answer 2

Theoretically, an entity may acquire funds in two basic ways: 1) by incurring debt, i.e., receiving a loan; and 2) by offering to exchange an equity position (ownership in the entity) for capital. Getting these funds is entirely dependent on the particular facts of the entity such as its history, longevity, previous financing, financial performance, assets, etc. To answer your question, one must determine what is meant by "cheaper". Debt is different than equity because it involves usually fixed sums with interest which must be repaid at some point. Equity involves an exchange of ownership (and usually future financial performance), with no attendant fixed sum to repay, and no interest. Dividends would only be payable upon the election of the directors, and are elective in nature. Giving an investor a piece of the company may or may not be cheaper than a bank loan. Again it is completely dependent on the facts of the entitiy in question.