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In our previous blog, we compared advantages and disadvantages of debt and equity financing. Today, we’re analyzing why (and if) debt is cheaper than equity.
This is a very common question. When companies refer to debt versus equity they are usually comparing the cost methods of obtaining financing; the additional capital is often needed to finance expansion or to continue operations. As discussed in our previous blog, two of the most basic ways to finance is through a loan (i.e., debt) or by selling a stake in the company (i.e., equity).
When comparing the cost of debt (e.g., a loan) to the cost of equity (e.g., selling a stake of the company) we need to consider how the interest a company would pay over the lifetime of the loan compares to the portion of profits an owner sacrifices over the lifetime of the company. If the interest paid on the loan is less than an outside investor’s cut of the company’s profits, then debt would be less expensive, and vice versa.
As the cost of debt is finite and the company will not have any further obligations to the lender once the loan is fully repaid, generally debt is cheaper than equity for companies that are profitable and expected to perform well. In other words, the more profitable a company is or will be, the more costly it is to sacrifice equity, as it is more beneficial for an owner to simply keep the profits and pay interest.
Usually debt is secured although not always, by having priority claim on a company’s assets; if the company fails to meet certain loan obligations, such as the debt covenants, or if the company declares bankruptcy, the lenders would be able to sell the company’s assets to recover a portion of the money they lent the company. Equity holders on the other hand, usually have a residual claim on the company’s assets once all the obligations of the company have been satisfied. Given the higher risk that equity holders have in losing everything they invested should a company fail, equity holders would generally demand a greater return to compensate them for taking on this additional risk.
There are limits however to the amount of debt lenders will typically allow, as the higher amount of debt a company carries the higher the risk the company may default. As such, after a certain level of debt it may be unlikely for a company to take on additional debt because the company will be over-leveraged, or the cost of additional debt will be substantially higher to compensate the lender for taking on this additional risk.
In summary, although debt is generally a cheaper source of financing compared to equity, this is not always the case and will depend on the financial stability and circumstances of the company.