Why is debt cheaper than equity?

Debt is cheaper for two reasons. Lenders take less risk than shareholders, so they accept a lower return, and the interest is tax deductible. Start with risk. A lender gets contractual interest payments and its money back at maturity, and if the company fails it's paid before shareholders. A shareholder gets whatever is left after everyone else is paid, which could be a lot or nothing. Because that claim is last in line and uncertain, shareholders demand a higher return. Then tax. Interest is deducted before tax, and dividends aren't. Say a company borrows at 6% and pays tax at 25%. Every $100 of debt costs $6 of interest, but that interest cuts the tax bill by $1.50, so the real cost is $4.50, or 4.5%. That doesn't mean a company should fund itself entirely with debt. As it borrows more, the chance of default goes up, so lenders charge more.

Debt is cheaper for two reasons. Lenders take less risk than shareholders, so they accept a lower return, and the interest is tax deductible. Start with risk. A lender gets contractual interest payments and its money back at maturity, and if the company fails it's paid before shareholders, often with collateral behind the loan. A shareholder gets whatever is left after everyone else is paid, which could be a lot or nothing. Because that claim is last in line and uncertain, shareholders demand a higher return. Then tax. Interest is deducted before tax, and dividends aren't. Say a company borrows at 6% and pays tax at 25%. Every $100 of debt costs $6 of interest, but that interest cuts the tax bill by $1.50, so the real cost is $4.50, or 4.5%. That's the 6% times one minus the tax rate. If shareholders want 10%, debt costs less than half as much. That doesn't mean a company should fund itself entirely with debt. As it borrows more, the chance of default goes up, so lenders charge more. Equity gets more expensive too, because more fixed interest comes out ahead of shareholders and their returns swing more. At first, adding cheap debt lowers the overall cost of capital. Past some point, the rising cost of both outweighs that, and the overall cost goes back up. Two caveats. The tax saving only exists if the company has profits to shield, and tax rules can cap how much interest is deductible. And cheaper doesn't mean safer. Interest is owed in a bad year, while a dividend can be cut.