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.
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