Why debt usually costs a firm less than equity

The cost of a source of finance is the return its suppliers require. Debt is generally the cheapest source, for these reasons.

1. Tax deductibility of interest. Interest is a deductible expense in computing taxable profit, so the effective cost of debt is the interest rate × (1 − tax rate); dividends are paid out of taxed profit and give no such saving. Debt is cheaper than shares, and even than preference capital, because of this tax advantage. For example, 12% debt costs only 12% × (1 − 0.30) = 8.4% after tax at a 30% tax rate.
2. Lower risk to the lender. Debt-holders receive a fixed, contractual interest whether or not the firm earns a profit, are repaid at maturity, and rank before shareholders in a liquidation; debt is often secured on assets. Equity holders get only the residual profit and residual assets. Since the lender bears less risk, it demands a lower return.
3. Fixed and certain return. Interest does not depend on the firm's performance, whereas dividends are uncertain and may not be paid; equity investors therefore require a risk premium.
4. No flotation and dilution cost of the same size. Debt issues usually cost less to arrange than equity issues, and they issue no new shares, so they do not dilute control; they raise earnings per share only when the funds earn more than the cost of the debt.
5. Equity carries an implicit cost. Even retained earnings, with no explicit payment, have an opportunity cost equal to what shareholders could earn elsewhere at the same risk.

Caution. The advantage holds only within limits: as debt rises, the firm's financial risk rises, lenders charge more and the cost of equity also rises, so a firm cannot lower its overall cost of capital indefinitely by adding debt.