## Why Debt is a Cheaper Source of Finance
### Learning Objective
Understand the three key reasons why debt financing costs less than equity financing.
### The Three Reasons
#### 1. Tax Benefit (Interest Tax Shield)
Interest paid on debt is treated as a business expense under tax law — it reduces taxable income.
> Effect: After-tax cost of debt = Interest Rate × (1 − Tax Rate)
>
> Example: 10% interest + 30% tax rate → Effective cost = 7% (not 10%)
Equity dividends, by contrast, are paid out of after-tax profits — no tax deduction is available.
#### 2. No Dilution of Control
- When a company borrows money, ownership structure does not change.
- Issuing new equity shares gives new shareholders voting rights, diluting the existing shareholders' control.
- Debt holders are lenders, not owners — they have no voting rights.
#### 3. Lower Required Return (Risk Perspective)
- Creditors take less risk than equity shareholders because:
- They have priority in repayment (both during operations and in liquidation).
- They receive a fixed, contractual return.
- Because their risk is lower, they demand a lower rate of return.
- Equity shareholders, bearing residual risk, demand a higher return as compensation.
### Summary
| Feature | Debt | Equity |
|---|---|---|
| Tax on cost? | No (deductible) | Yes (paid from after-tax profit) |
| Dilutes control? | No | Yes |
| Required return | Lower (fixed, priority) | Higher (residual, uncertain) |
This is why debt is consistently called the cheaper source of finance in financial management.