Question

Are taxes necessary for the cost of debt financing to be less than the cost of equity financing?

Answer 1

No.

Cost of equity will be always higher than cost of debt irrespective of taxes

Two reasons are:

1. A credit holder will always have a superior claim over the company than equity holder. Even when the company is liquidated, the credit holder will get their portion then the equity holder. Now, since, the risk associated with equity holder i high, the cost of equity will also be high

2. Suppose taxes are zero, then cost of debt increases but Levered beta is also dependent on tax, hence, in case of zero tax levered beta will also increase and will eventually increase cost of equity.

Levered beta = unlevered beta*(1+(1-tax)*(D/E))