Question

In what kind of scenario would debt be much cheaper for the company overall? When might they end up paying more because they used debt?

Answer 1

In general debt is much cheaper for the company overall because of the following reasons-

• The riskiness: the risk associated with debt is generally lower in comparison of equity and we know that risk and return go hand by hand. Therefore debt financing is usually cheaper than equity financing and interest rates are lower in comparison of dividends as the shareholders need more return to compensate higher risk associated with equity.
• Tax benefits: The interest expense on debt of the company is deducted before calculating the taxable profit of the company therefore it reduces the tax liability of the company and make debt financing even more low-cost.
• Flotation Cost: Flotation cost is the cost of raise the capital. It is generally higher for equity financing and included into cost of capital while for debt financing; flotation cost is lower which makes it cheaper.

They might end up paying more because they used debt when the company becomes over-leveraged or borrow more debt than a certain level. The cost of raising additional debt sometime become more costly as borrowing becomes more and more expensive. The initial lenders have first claim on the company's assets while the subsequent lenders will have residual claim therefore they charge more interest as the lending becomes riskier due to repaying capacity of the company.