It’s a fact that debt is a cheaper source of finance than equity on the following bases.
| Facts | Detailed discussion |
| Tax advantage | The interest payment is deductible from taxable income. It means payment of the interest leads to a decrease in taxable income and tax liability. Hence, the cost of debt financing decreases. On the other hand, payment of dividend on equity is not tax deductible. So, equity does not carry tax advantage. Hence, it’s a little more expensive. |
| Control dilution | The company obtaining financing is not required to dilute its control if they opt for debt financing. On the other hand, equity financing leads to more owners of the company and reduced controlling power of existing shareholders. Hence, it cost existing shareholders in terms of control. So, debt is a cheaper and more desirable source of finance. |
| Risk intensity for funds provider | The risk intensity carried by debt for funds providers is comparatively lower. Hence, their return is lower as well. Think like this, if the company defaults, debtors stand first in the queue to claim over the company’s assets. Hence, they have higher chances to recover their debt. It means their risk is comparatively lower than equity holders that stand second in the queue. |
| The debtor can get some cover by covenant | Debtors can include covenants in their lending agreements to protect themselves. For instance, they might include a covenant in the lending agreement that if ROE decreases lower than 15%, the debt immediately becomes payable. Hence, there is some kind of protection for the debtors. It means their risk of losing their principal amount is less. So, their return should be lower as well. On the other hand, equity investor does not have the option to include a repayment covenant while investing. |
Although, debit is a cheaper source. It does not mean that a company/business should only be focused on raising finance via debt. It’s because of the fact that raising higher debt might lead to a higher rate of default for the business raising finance. So, there is a need to maintain some balance between debt and equity components in the financing structure of the business.
Also read, statement of owner’s equity
Conclusion
Generally, debt is a cheaper source of finance than equity because of the following,
Tax deduction – Interest paid on debt is deductible from taxable income.
Dilution control – Raising finance via debt does not dilute control of existing shareholders. On the other hand, raising finance via equity leads to decreased control of existing shareholders. Hence, it cost existing shareholders in terms of control.
Risk intensity for funds provider– If you invest funds as a debtor, you stand first in the queue to claim over the company’s assets in case of default. Hence, debt financing carries a lower risk and lower cost of financing.
Repayment covenants– As a debt holder, you can include some repayment covenant in the lending agreement. On the other hand, it’s not the case with equity investment, they may not be able to provide any repayment protection. Hence,
‘’risk of equity inventors is higher than debt investors. Hence, equity is comparatively expensive and debt financing is comparatively cheaper due to lower risk’’
