Which is cheaper, debt or equity?

Debt v/s Equity
Debt v/s Equity - Image Source:

The Cost of Equity is higher than the Cost of Debt since equity investors take on more risk when purchasing a company’s stock as opposed to a company’s bond. Therefore, an equity investor will demand higher returns than the equivalent bond investor to compensate him/her for the additional risk that he/she is taking on when purchasing stock.

While the Cost of Debt is usually lower than the cost of equity (for the reasons mentioned above), taking on too much debt will cause the cost of debt to rise above the cost of equity. This is because the biggest factor influencing the cost of debt is the loan interest rate (with issuing bonds, the bond coupon rate).

As a business takes on more and more debt, its probability of defaulting on its debt increases. This is because more debt equals higher interest payments. If a business experiences a slow sales period and cannot generate sufficient cash to pay its bondholders, it may go into default. Therefore, debt investors will demand a higher return from companies with a lot of debt, in order to compensate them for the additional risk they are taking on. This higher required return manifests itself as a higher interest rate.

The optimal capital structure is therefore one that minimizes the Weighted Average Cost of Capital (WACC) by taking on a mix of debt and equity.

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