David Lombardy, Member
This is a very common question, and I’m glad that you asked it. What people are referring to when they talk about debt being cheaper than equity is how much it costs a business or company to obtain the financing it needs. Two of the central ways to do so are via loans and by selling a certain stake in the company.
Now, when you compare the cost of debt (i.e. a loan) to that of equity (i.e. selling a stake of the company), you need to consider how the interest you would pay over the lifetime of a loan would compare to the portion of profits you’d sacrifice over the lifetime of the company. If the interest would be greater than an investor’s cut of your profits, then debt would be more expensive, and vice versa.
Given that the cost of debt is essentially finite (you have no obligations once it’s paid off), it’ll generally be cheaper than equity for companies that expect to perform well. In other words, the more you expect to profit, the most costly sacrificing equity will be and the more beneficial it will be to simply keep the profits to yourself and pay interest on a loan. For example, if you’re going to be making $100k next year, you’d much rather pay $10k in interest than give up 10% of your profits forever. This is especially true when you consider that interest paid on loans is tax deductible.
It’s obviously difficult to forecast earnings with any certainty, which is why large companies with steady cash flow that are in stable industries tend to make greater use of debt, while less-established companies or those in risky fields may not only find equity to be less risky, but easier to acquire as well.
To answer the question of why debt is cheaper than equity we need to understand what is meant by debt and equity. An item that qualifies as debt is interest rates while an item that qualifies as equity is the internal rate of return, and together debt and equity refer to how much money the company needs to finance. The cost of debt is usually 4% to 8% while the cost of equity is usually 25% or higher.
Debt is a lot safer than equity because there is a lot to fall back on if the company does not do well. Therefore in many ways debt is a lot cheaper than equity.
The following is an example of why debt is cheaper than equity:
Say you are a business owner and you need $10,000.00 in order to get your business up and running. You have two options to get this $10,000.00. Your first option is to take out a bank loan at 5% interest rate, while your second option is to have someone take out a share at 30% for $10,000.00.
If your business earns $30,000.00 after one year of being opened and you took out the bank loan then the money you would have to pay to the bank would be $500.00 which would leave you with a total of $29,500.00 in profit.
However, if you sold a share of your company to someone at 30% you would have to give that person a total of $9,000.00 which would leave you, the business owner, with a total of $21,000.00.
So had you taken out debt instead of equity you would have received $8,500 more in profit.
In this example you can see why debt is a lot safer than equity and why you could potentially receive a lot more money with debt than you can by equity.
30,000 - 10,000 of debt minus 500 of interest is 19,500. In the short run is was better to take the cash in return of the profits. However, in the long term, it is a terrible move.
JOHN DANIEL, Member
i am also wondering about this
Did we answer your question?