Why is debt a comparatively cheaper form of finance than equity?

Because debt is a fixed amount that can be repaid, with the owners of the business retaining full ownership after repayment. Equity makes one an owner of a (presumably) growing business and therefore of potentially huge value and an indeterminate loss to the original owners Answer I am not sure I would agree with the above and it seems circular at best (although perhaps it's trying to address the dilution of value to existing stock holders when more stock is issued)- but the common answer is because of the tax effect difference between dividends and interest business finance considers debt less expensive than equity because the payments on debt - interest - are before earnings and receive a tax deduction as a business expense. Whereas, dividends, which are how you pay equity financing, are not tax deductible and are paid from after tax earnings So, in a 35% tax rate (the current federal corp tax rate), paying $100 of interest has the same cost to the company as paying $65 of dividends.

Adding the effect of State taxes, etc. Even increases the effect Paying the same of in dividends, the amount paid gets no tax benefit and has a real cost of the $100. So, you can carry much more debt for the same net cost as using the dividend/equity option Finally, debt (credit line or bonds) can be easily replaced and refinanced should interest rates fall, or the company has a credit rating improvement. Equity, once in place, is there to stay Answer In addition to the above.

Debt is cheaper than equity because providers of debt are exposed to less risks than providers of equity (shareholders). This is because (1) interest needs to be paid out regardless of net income, while dividends can only be paid when the firm has been profitable, and, (2) in case of bankrupcy, debt providers have priority over shareholders.

This can be easily explain using financial theory Debt financing is cheaper than equity will hold true only when 1) your company wiil be taxed on any profits 2) your company will make profits 3) Interest paid on debt financing is tax deductable 4) your company will reach at least the same sales figure with or without debt This is because the benefit of "Tax Sheild" which arised from the fact that government allows interest paid on debt financing to be tax deductable. For example, if your company makes 1 million in profit, if you have debt, you can use interest paid on debt to lower your taxable profit. Therefore, the government will calculate your tax from 1million less interest paid on debt not the full 1million.

Saving from paying lower tax will eventually be resulted back into shareholders' pocket To understand that debt is cheaper financing than equity, you must not look at the ending profit because your net profit will be lower than not having debt BUT the cash flows to shareholders and debt holder will be higher as a result from the transfer of tax saving.

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