Cost of Debt vs. Equity: Key Differences and Impact on Business

Search Fintrev

Search our guides, reviews and glossary.

Debt is cheaper than equity because lenders take less risk than shareholders and the tax code subsidizes interest. A lender has a contractual right to interest and principal and is paid before shareholders receive anything, so it accepts a lower return. A shareholder has no promised payment, is paid last, and demands a higher expected return for that uncertainty. On top of that, interest on business debt is generally tax deductible, which lowers the after-tax cost of borrowing, while dividends paid to shareholders are not deductible. The answer holds only up to a point: as a company borrows more, both its cost of debt and its cost of equity rise, and a business that cannot use the tax deduction loses much of the advantage.

Why the cost of equity is higher than the cost of debt

The cost of capital is the return investors require for handing a company their money. Debt and equity investors face different risks, so they require different returns. Three mechanisms explain the gap.

Lenders get paid first

A loan or bond is a legal obligation. The company owes interest on schedule whether it earns a profit or not, and interest must be paid before any dividend goes to shareholders. If the business fails, creditors are repaid from the assets before shareholders, who receive only what is left, often nothing. Secured lenders go further and hold collateral they can claim on default.

Shareholders sit at the bottom of that order. Their return depends on future profits and on what the market will pay for the stock, and they absorb losses first.

Interest is tax deductible; dividends are not

In the United States, interest a business pays on its debt is generally deductible as a business expense (the IRS covers this under Topic No. 505, Interest Expense). Every dollar of interest reduces taxable income, so the government effectively pays part of the interest bill. Dividends are paid out of after-tax profits and earn no deduction. This tax shield is why analysts quote the cost of debt on an after-tax basis but the cost of equity has no such adjustment.

The deduction has limits. Under Section 163(j) of the Internal Revenue Code, many larger businesses can deduct net business interest only up to a cap tied to their adjusted taxable income, with the excess carried forward. Other countries apply their own rules.

Lenders accept a capped return

A lender’s best outcome is to be repaid in full with interest; it does not share in any upside if the company triples its profits. Shareholders share in that upside but also bear the downside, so their open-ended, residual claim requires a higher return. Equity also has a non-cash cost: issuing shares dilutes existing owners’ stakes and voting power, while borrowing leaves ownership unchanged.

How each cost is measured

Cost of debt

For a simple loan, the pre-tax cost of debt is its interest rate. For a company with traded bonds, analysts usually use the yield to maturity on that debt rather than the coupon, because the yield reflects what lenders currently demand. The after-tax figure is:

After-tax cost of debt = Rd × (1 − t)

where Rd is the pre-tax rate and t is the company’s tax rate. The rate a company can borrow at depends on its credit quality, collateral, the loan’s term and the general level of interest rates.

Cost of equity

Equity has no stated rate, so the cost has to be estimated from what shareholders could reasonably expect. The most common tool is CAPM:

Cost of equity = Rf + β × (Rm − Rf)

• Rf is the risk-free rate, typically a government bond yield.
• β (beta) measures how much the stock moves relative to the overall market.
• Rm − Rf is the equity market risk premium, the extra return investors expect from stocks over the risk-free rate.

Other methods exist, such as the dividend discount model, which backs out the required return from the dividend and its expected growth. Either way, the result is an estimate built on assumptions, while the cost of debt can usually be read from a loan agreement or bond yield.

Example: comparing the two (hypothetical)

A company borrows $100,000 at 7% interest and pays tax at a 21% rate.

• Pre-tax cost of debt: 7%
• After-tax cost of debt: 7% × (1 − 0.21) = 5.53%

Assume a risk-free rate of 4%, a beta of 1.2 and a market risk premium of 5%.

• Cost of equity: 4% + 1.2 × 5% = 10%

On these assumptions, each dollar of equity costs the company almost twice as much as a dollar of debt. Companies usually combine the two into a weighted average cost of capital (WACC). If the company is funded 60% with equity and 40% with debt:

• WACC = 0.60 × 10% + 0.40 × 5.53% = 8.21%

WACC is the hurdle rate a project must beat to create value, and it is the discount rate many analysts apply to future cash flows when valuing a business.

When debt is not cheaper

The example suggests a company should simply borrow more and lower its WACC. Several forces stop that from working indefinitely.

More debt raises the cost of equity. Interest is a fixed claim that comes ahead of shareholders. The more of it there is, the more volatile the profits left for shareholders become, which increases the equity’s beta and its required return. Leverage magnifies returns on equity in good years and losses in bad ones. The Modigliani-Miller theorem formalizes this: in a world without taxes, bankruptcy costs or market frictions, the rising cost of equity exactly offsets the cheaper debt, and the mix of debt and equity does not change a firm’s overall cost of capital. In the real world, the tax deduction is the main reason debt still lowers WACC.

More debt raises the cost of debt. Lenders charge higher rates as leverage climbs because the chance of default rises. Past some point, the company faces financial distress costs: tighter covenants, demands for collateral, lost customers or suppliers, and legal costs if it fails. Those costs can outweigh the tax benefit.

The tax shield only helps a profitable taxpayer. A company with losses, or one whose interest exceeds the deductible cap, gets little or no immediate tax benefit. Its after-tax cost of debt is close to the full interest rate, and the gap with equity narrows.

Some businesses can barely borrow. Early-stage companies without steady cash flow or assets to pledge may find loans unavailable or available only at very high rates. For them, equity can be the only practical source, and the comparison is about access as much as price. Equity also brings things debt does not, since large investors may contribute expertise, contacts and patience that a lender will not.

Fixed payments are a cash-flow risk, not just a cost. Debt service is due regardless of results, so a business with uneven revenue can run short of cash even when its average cost of capital looks low. Interest and principal payments show up on the cash flow statement, and that is where the strain appears first.

FAQs

The Bottom Line

Business owners and analysts weighing how to fund a company can usually expect debt to cost less than equity, mainly because lenders take less risk and interest is tax deductible. That edge shrinks as leverage rises, disappears for firms that cannot use the deduction, and does not help companies that cannot borrow. Fixed debt payments also strain cash flow, so the cheapest mix depends on profits, assets and revenue stability.