What do people mean when they say debt is a relatively cheaper form of finance than equity?

What do people mean when they say debt is a relatively cheaper form of finance than equity?

 

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In this case, the "cost" being referred to is the measurable cost of obtaining capital.

• With debt, this is the interest expense a company pays on its debt.
• With equity, the cost of capital refers to the claim on earnings which must be afforded to shareholders for their ownership stake in the business.

 

For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for $40,000.

 

• Suppose your business earns $20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
• Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000).
• From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity.
• Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).

 

Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage, as it presents a fixed expense, thus increasing a company's risk.

• Going back to our example, suppose your company only earned $5,000 during the next year.
• With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000).
• With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% x $5,000).
• So, as you can see, provided a company is expected to perform well, debt financing can usually be obtained at a lower effective cost.
• However, if 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.

 

Companies are never 100% certain what their earnings will amount to in the future (although they can make reasonable estimates), and the more uncertain their future earnings, the more risk presented.

• Thus, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations.
• New businesses with high uncertainty may have a difficult time obtaining debt financing, and thus finance their operations largely through equity.

 

(For more on the costs of capital, see Investors Need A Good WACC.)

 

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