Debt versus Equity, Which Capital Structure is Cheaper?
Updated: Aug 31
In general, debt financing may be cheaper in the short term because it usually involves a fixed interest rate that the business is required to pay back to the lender. Additionally, interest paid on business debt is usually tax-deductible, which can reduce the overall cost of borrowing.
On the other hand, equity financing can be more expensive in the long term because it involves giving up a portion of ownership in the business in exchange for funding. This means that the business will have to share its profits with investors, and the cost of equity financing will continue as long as the business is profitable.
However, debt financing comes with the risk of default if the business is unable to make the required payments. In contrast, equity financing does not require the business to make regular payments and does not have a fixed repayment schedule, which can provide more flexibility for the business.
The specific reasons why raising debt could be cheaper than equity include:
Tax benefits: Interest paid on debt is tax-deductible for the borrower, which reduces the effective cost of borrowing. In contrast, dividends paid on equity are not tax-deductible.
Priority in Bankruptcy: In the event of bankruptcy or liquidation, debt holders have priority over equity holders in terms of the right to recover their investment. As a result, debt is generally considered less risky than equity and therefore carries a lower cost.
Fixed payments: Debt payments are typically fixed and predictable, which reduces the uncertainty and risk for lenders. Equity, on the other hand, represents a share of ownership in the company and is therefore subject to greater variability and uncertainty in terms of returns.
Market demand: There is often a greater demand for debt financing than for equity financing, which can result in lower interest rates and more favourable terms for borrowers.
However, it's important to note that the cost of debt and equity can vary depending on a number of factors, such as the perceived risk associated with the investment opportunity, market conditions, and the creditworthiness of the borrower.
Additionally, excessive debt can increase the financial risk for the borrower and reduce its ability to respond to changes in the market, which can offset the benefits of lower borrowing costs. As such, it's important for companies to carefully consider the costs and benefits of capital structure and to choose the financing structure that is most appropriate for their needs.