Why is Debt Cheaper than Equity?

This video explains the reasons why Debt is less riskier and cheaper than equity. The concepts explained would be useful for Finance students at beginner level.

Hi my name is karthik shetty and this presentation is on why is debt cheaper than equity but first let us understand what do they basically mean debt is an amount borrowed by a company or a firm with a promise to pay back the principal amount along with interest common examples include bank loan bonds and debentures while equity is an investment by shareholders or

Owners in exchange of a stake in the company or a firm debt promises the investor to pay back the amount borrowed along with a sum of interest now the interest could be variable or fixed in nature nevertheless it is based on a pre-negotiated understanding between the borrower and the lender while in equity there is no such understanding between the investor and

Company hence in debt there is a legal obligation to pay back but inequity there is no such obligation that said if a company does not give consistent returns in the long run to its equity holders it can damage its reputation in the financial markets thus making the future fundraising activities more difficult in both debt and equity markets the debt holders

Enjoy another advantage that is interest and principle are given higher priority in the payment plan although in real life companies will have a much more complicated payment waterfall as what is shown on this current slide but i hope this would give you a basic understanding as you can see generally companies prefer making payments towards a direct materials

Pages and factory expenses and after which they pay other monetary expenses such as salaries interest principal and rent insurance these kind of expenses have a specific due date and therefore are not only critical but also obligatory payments in nature and after these there are other categories of expenses which are incidental and discretionary in nature a

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Few examples include general sales and administrative costs advertising expenses and marketing costs while these are important expenses however the amount can be increased or decreased depending on the revenue and profitability being generated dividends only can only be paid out of net profit and net profit is the amount that remains for the company after paying

Taxes from profit before taxes dividends can only be paid from net profit and as mentioned before a company still has a choice whether to pay dividends or not besides debt can be secured a debt can be secured against assets such as land building shares deposits machineries etc in certain cases banks or financers can also ask for personal guarantees to be given

By promoters of the company resultantly secured debt is cheaper than unsecured debt and yet unsecured debt will be significantly cheaper than equity in a nutshell amongst the three avenues of funding equity will be the most expensive while unsecured debt will be less expensive than equity it will be more expensive than secured debt and secured debt would be the

Cheapest form of funding providing security to lenders can give a reasonable assurance that their money will be paid back by the borrower since in idle conditions no company would be willing to let go of their assets now what happens in a worst case scenario in simple terms a company could cease to physically exist in a worst case scenario a company will have

To let go of their employees and sell all their assets in order to repay the lenders and creditors this is called liquidation an event of liquidation is most often triggered by default if the company is unable to pay its lenders or creditors in liquidation assets of the company would be sold and if that asset is secured against a particular debt facility the

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Proceeds will be first paid back to the relevant lenders the remaining proceeds will be used to pay statutory dues fees of the liquidator wages salaries unsecured portion of debt unpaid portion of secured debt if any eventually equity shareholders will be paid and more often than not the proceeds will be negligible as compared to their original investment so which

Is riskier equity or debt of course equity is riskier because debt is protected in many forms as explained before and therefore the return expected by equity investors would be significantly higher than debt thus making debt cheaper than equity but does it mean that debt is a better form of fundraising than equity because it is cheaper and whether it is a better

Investment avenue because it is less riskier the answer is not that straightforward and for for this to dig deeper we’ll have to understand both investors and the company’s perspective let’s begin with investors point of view the preference to invest whether on debt or equity depends on the risk appetite of the investor an investor who is more risk-averse in

Nature will prefer to invest through debt while on the other hand if the investor is more open towards risk and have a high and has a higher expectation of return would prefer investing through equity a debt gives stable income with more certainty even though the interest rate would be variable in nature it can be better predicted as compared to equity an equity

Does promise a higher income in a way and over a longer term beats inflation but remember if the underlying equity investment does not perform well the return can also be negative and therefore if the investor is an individual it is recommended to have a healthy mix of debt and equity in their portfolio but that being said it also depends on the organizations

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Objective for example banks are supposed to give loan to borrowers by taking money from the depositors and because they are regulated by the central banks of the respective countries they cannot invest through equity in idle conditions but on the other hand organizations like private equity firms and hedge funds have a higher expectation of returns and they

Prefer investing through equity let us understand a company’s perspective the first thing that is worth highlighting is that raising funds through debt and equity is not mutually exclusive in fact most of the listed firms in fact or almost all the listed firms have bought debt and equity in the balance sheet as sources of their funding that being said debt is

Mostly preferable by mature companies who would consistently generate positive ebitda cash flow and revenue so as to service their debt equity is preferred by high growth companies such as startups or companies which are smaller in scale equity could also be preferred by matured companies if they have new projects in pipeline which are yet to break even another

Advantage of having debt in a funding mix is that it helps in increasing the return on equity to equity shareholders for example if a company generates a return of 15 percent while the average interest rate is 7 for the company the remaining 8 percent automatically belongs to the equity shareholders thus increasing the returns to conclude debt is cheaper than

Equity because of the lower risk associated with it there is a reasonable assurance on receiving back the principle along with interest amount while equity being a riskier asset commands higher return but that said debt and equity mutually co-exist with together and derive benefit from each other this is karthik shetty and thank you for your time

Transcribed from video
Why is Debt Cheaper than Equity? By Finance With Kartik