Why Debt Capital is Cheaper than Equity Capital

Why debt capital is cheaper than equity capital? Why is business not 100% debt financed? Answer: When a firm raises money for capital by selling debt instruments to investors, it is known as debt financing and the capital obtained is called debt capital. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid on a regular schedule. On the other hand, equity capital is raised through equity financing which is the process of raising capital through the sale of shares in a company. With equity financing comes an ownership interest for shareholders. Equity financing can be obtained through private investor or through public sale of shares in stock exchange. Provided that a company is expected to perform well, debt financing can usually be obtained at a lower effective cost and is a better financing option. For example, a small business that needs $40,000 of financing can either take out a $40,000 bank loan at a 10% interest rate or sell a 25% stake in the business to someone else for $40,000. Suppose the business earns a $20,000 profit during the next year. If it took the bank loan, its interest expense (cost of debt financing) would be $4,000, leaving it with $16,000 in profit. Conversely, had it used equity financing, it would have zero debt (and as a result, no interest expense), but would keep only 75% of the profit. Therefore, the profit of the original owner would only be $15,000, or (75% x $20,000). From this example, it can be seen how it is less expensive for the owner of the company to issue debt as opposed to equity. Due to the presence of taxes, debt capital yields in relatively higher bottom line than similar amount in equity capital since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield. If the tax rate were 35%, then the company’s’ tax savings would be equivalent to the interest payment multiplied by the tax rate. As such, the shield is $40,000 x 10% x 35% = $1,400. The intuition here is that the company has $40,000 reduction in taxable income since the interest expense is deductible. This reduces the tax it needs to pay by $1,400. Under such circumstances, debt capital is cheaper than equity capital. However, the advantage of the fixed-interest nature of debt can also be a disadvantage if the company’s performance is unsatisfactory. Debt capital presents a fixed expense, thus increasing a company's risk and also deteriorates its ability to further take debt. In the same example, suppose the company only earned $5,000 during the next year. With debt financing, it would still have the same $4,000 of interest to pay, so it would be left with only $1,000 of profit ($5,000 - $4,000). With equity, it would again have no interest expense, but only keep 75% of the profits, thus leaving it with $3,750 of profits (75% x $5,000). Hence when a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing. A company with a lot of debt can be easily pushed into bankruptcy by small misfortunes, just shown by the above example. One major risk associates it debt financing is bankruptcy risk which increases with the proportion of debt taken.Let us consider an airline with a small amount of debt that's faced with a couple of bad years in a row due to high jet fuel prices. When necessary, the airline can always sell off a plane or two to repay what it owes. But if that exact same airline has a lot of debt, then liquidating enough assets (i.e., selling enough planes) to repay the debt is going to eventually cripple the company. As long as business is good, the highly indebted airline can keep using profits to pay what it owes. But if business takes a downward turn, the airline is going to be in very serious trouble and may need to file for bankruptcy and not even fully repay its debt. Because heavily indebted (highly leveraged) companies are at greater risk of going bankrupt, lenders (whether banks or the bond market) typically demand a high interest rate to loan to them. In other words, the more debt a company carries, the more expensive additional debt becomes. Because of these types of risks, businesses are usually not fully debt financed.