Why is Debt Cheaper than Equity?

Summary

In this presentation, Karthik Shetty explains why debt is generally cheaper than equity. He defines debt as a borrowed amount with an obligation to repay with interest, while equity represents ownership in a company with no repayment obligation. Debt offers lower risk due to priority in payment and potential asset security, making it cheaper than equity, which is riskier and requires higher returns. While debt can be cheaper for companies, the choice between debt and equity depends on factors like the company's maturity, growth stage, and financial stability, as well as the investor's risk appetite.

Takeaways

• 😀 Debt is an amount borrowed by a company with a promise to repay both the principal and interest, while equity represents an investment by shareholders in exchange for ownership.
• 😀 Debt carries a legal obligation to pay back, whereas equity does not have a fixed repayment obligation.
• 😀 In case of financial difficulty, debt holders have higher priority for repayment compared to equity shareholders.
• 😀 Debt can be secured against assets like land, buildings, and machinery, making secured debt cheaper than unsecured debt.
• 😀 Unsecured debt, although more expensive than secured debt, is still cheaper than equity due to the lower risk for lenders.
• 😀 Equity is riskier for investors because it doesn't guarantee returns, and shareholders may get minimal returns or none at all in case of company failure.
• 😀 In a worst-case scenario, such as liquidation, debt holders are paid first from the proceeds of asset sales, while equity shareholders are last and may receive negligible amounts.
• 😀 Investors' preference for debt or equity depends on their risk appetite: risk-averse investors lean towards debt, while those willing to take higher risks prefer equity for potentially higher returns.
• 😀 Debt provides more predictable returns due to fixed or variable interest, making it a stable income option compared to the more volatile returns of equity investments.
• 😀 Companies typically prefer debt for funding if they have stable cash flow, while high-growth companies or startups may prefer equity to avoid repayment obligations.
• 😀 The combination of debt and equity on a company's balance sheet is common, as both types of funding offer distinct benefits and can be used strategically to support growth and optimize returns on equity.

Q & A

What is the main reason debt is cheaper than equity?

Debt is considered cheaper than equity because it carries lower risk. Debt holders have a legal obligation for the company to repay them, and in case of liquidation, they are paid before equity holders, making it less risky for lenders.

How does the repayment structure of debt and equity differ?

Debt involves scheduled repayments, including both principal and interest, and these payments have a higher priority in the company's payment waterfall. Equity holders, however, receive dividends only from the company's net profit, and payments to them are not guaranteed.

What types of debt are cheaper, and why?

Secured debt is cheaper than unsecured debt because it is backed by company assets, offering more security to the lender. Unsecured debt is more expensive than secured debt but still cheaper than equity.

What is liquidation, and how does it impact debt and equity holders?

Liquidation occurs when a company is unable to meet its financial obligations, leading to the sale of its assets. In this process, debt holders are paid first, while equity shareholders are paid last and often receive minimal or no return.

Why is equity riskier than debt?

Equity is riskier because it does not guarantee a return, and in cases of financial distress or liquidation, equity holders are paid last, after all debts have been cleared. Additionally, if the company performs poorly, equity investors may face negative returns.

How does a company's stage of growth affect its preference for debt or equity?

Mature companies with consistent cash flows typically prefer debt, as they can reliably service it. Startups or high-growth companies, which may not yet have stable cash flow, tend to favor equity as it carries less immediate obligation.

What impact does using both debt and equity in a company’s financial strategy have?

Using both debt and equity allows companies to balance the lower costs of debt with the growth potential of equity. Mature companies often use debt to lower their cost of capital, while startups use equity to minimize financial strain in early stages.

How do investors choose between debt and equity investments?

Investors choose between debt and equity based on their risk appetite. Risk-averse investors prefer the stability and lower risk of debt, while those seeking higher returns, and willing to take on more risk, typically prefer equity investments.

Can debt and equity coexist in a company’s financial structure?

Yes, debt and equity often coexist in a company's financial structure. Most companies use a combination of both to diversify their funding sources and optimize their capital structure, benefiting from the advantages of each.

Why might a company prefer to raise funds through debt instead of equity, even if it is cheaper?

A company may prefer debt over equity because debt financing does not dilute ownership. Raising funds through equity would mean giving up a stake in the company, whereas debt allows the company to retain full control.