Why Debt is Cheaper Than Equity
Giving up part of your business can feel daunting, particularly when it’s you who has taken the risks and poured in the courage, heart and tenacity required to build your business to where it is today – so what’s the alternative? In this article, we’ll cover debt financing advantages over equity financing to help you make the right decision for your business.
When it comes to raising capital for your business, there are two primary options: debt or equity. Whilst each has its pros and cons, debt financing is often considered more cost-effective than equity – so what exactly makes debt cheaper?
Lower Required Returns
One of the main debt financing advantages is that debt is cheaper than equity; the reason lies in the lower returns required by debt investors compared to equity investors, meaning debt is viewed as less risky – here is why:
- Priority in repayment: If the company faces bankruptcy, debt holders are the first to be repaid, making their investment more secure than equity holders.
- Contractual obligations: Unlike dividends paid to shareholders, interest payments on debt are mandatory. This guaranteed income makes debt a safer investment.
- No ownership: Debt financing doesn’t involve giving up control of your company. Investors don’t get a stake in the business – with the demands that come along with that – they simply expect repayment with interest.
As it is lower risk, debt investors are willing to settle for lower returns, translating to a lower cost of capital for your business.
Tax-Deductible Interest
Another significant benefit of debt financing is the tax deductibility of interest payments. This is a key advantage because:
- Interest paid on debt can be deducted from a company’s taxable income, reducing the overall tax burden.
- In contrast, dividends paid to equity shareholders are not tax-deductible, making equity more expensive after taxes are factored in.
This tax shield effect can substantially lower the after-tax cost of debt and make it an attractive option for financing your business.
No Dilution of Ownership
For business owners who want to retain control, debt financing is the clear winner. Unlike issuing new equity, debt does not dilute your ownership stake. Here’s why that matters:
- By avoiding equity financing, you maintain full control of your business.
- Existing shareholders don’t see their stakes diluted, which means they don’t have to share decision-making power or profits with new investors.
If protecting your ownership is a priority, debt financing the better choice.
Quantitative Comparison: Debt vs. Equity
When comparing the costs of debt and equity, it’s important to look at the numbers.
- The cost of debt is represented by the interest rate you pay on borrowed funds. This is generally much lower than the cost of equity.
- The cost of equity is usually higher because equity investors demand a higher Internal Rate of Return (IRR) to compensate for the increased risk they take by investing in your company.
With debt, you typically deal with a fixed, lower cost, whilst equity financing comes with a higher long-term price tag.
The Limitations of Debt Financing
Whilst debt financing has clear advantages, it’s important not to overlook the risks. Excessive debt can increase your financial risk, particularly if:
- The company takes on too much debt, increasing the risk of default.
- Debt servicing costs (interest and principal payments) become unsustainable, especially in times of reduced cash flow.
Striking the right balance between debt and equity — known as the optimal capital structure — is key to maximising your business’s financial health without overburdening it with risk.
Conclusion
Debt financing can be an excellent tool for businesses looking to grow without giving up ownership or paying the higher costs associated with equity financing. The lower required returns, tax benefits, and lack of ownership dilution make it a compelling option for many companies. However, it’s essential to manage debt carefully to avoid increasing financial risk.
If you’re considering debt financing for your business, it’s important to evaluate all your options. Altocrest Advisory is here to guide you through the process, ensuring you secure the best financing solutions for your unique needs.
Contact us today to discuss how we can help you optimize your capital structure and achieve your business goals.
