Why debt is the cheapest source; can a firm be wholly debt-financed?

Why debt is cheapest for a profit-making company

1. Lower risk to the lender, so a lower rate. Debt holders receive a fixed interest whatever the profits, rank ahead of shareholders and are often secured; their lower risk means interest rates are usually lower than the return equity shareholders demand.
2. Tax deductibility. Interest is an allowable expense in computing tax, so the effective cost of debt is reduced: after-tax cost Kd = I(1 − t) ÷ NP. A profit-making company actually earns this tax saving; a loss-making one does not, which is why the question specifies profit.
3. No dilution and low issue cost compared with an equity issue.

Can a firm opt for 100% debt financing? No. Some element of equity must always be there: even under the net income approach, which favours debt, the overall cost of capital approaches the cost of debt but never touches it, because there cannot be a 100% debt firm. In practice:

• as debt rises, the financial risk of both lenders and shareholders rises, so the cost of debt and of equity rise and the advantage of cheap debt disappears;
• lenders require an owners' stake (margin) and impose covenants limiting further borrowing;
• fixed interest must be paid even in bad years, so heavy debt threatens insolvency.

Conclusion. Debt is the cheapest source for a profitable firm, and some debt lowers the overall cost of capital, but beyond a point it raises risk and cost; a firm cannot, and should not, be financed wholly by debt.