The cost of debt is cheaper than equity for two connected reasons: the interest a company pays on its borrowings is tax-deductible, and lenders bear less risk than shareholders, so they accept a lower return. Together these forces pull the after-tax cost of a loan or bond well below what stock investors expect to earn, which is why most profitable companies fund a large share of their operations with debt before ever considering a new equity raise.
The Interest Tax Shield
The biggest driver of debt’s cost advantage is a federal tax rule. Section 163 of the Internal Revenue Code lets companies deduct “all interest paid or accrued within the taxable year on indebtedness” from their taxable income.1Office of the Law Revision Counsel. 26 US Code 163 – Interest Every dollar of interest expense reduces the income the company pays tax on. Finance professionals call this the interest tax shield.
The federal corporate rate is a flat 21%.2Office of the Law Revision Counsel. 26 US Code 11 – Tax Imposed Take a company that borrows $1 million at 5%. The $50,000 of annual interest is deductible, which cuts its federal tax bill by $10,500. The real out-of-pocket cost of that interest drops to $39,500, an effective after-tax rate of 3.95% instead of the stated 5%. The general formula: multiply the stated rate by (1 minus the tax rate).
Dividends get no equivalent treatment. Corporations pay dividends out of earnings that have already been taxed at the company level.3Internal Revenue Service. Topic No. 404, Dividends and Other Corporate Distributions To hand $50,000 to shareholders, the same company would first need to earn roughly $63,300 in pre-tax income and pay about $13,300 in corporate tax. The shareholders then owe personal tax on what they receive. That double layer is a structural reason equity is expensive.
Limits on the Interest Deduction
The shield isn’t unlimited. Section 163(j) caps the business interest a company can deduct in a year at its business interest income plus 30% of adjusted taxable income.4Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense A company that borrows heavily relative to its earnings can hit that ceiling, and excess interest carries forward to future years rather than disappearing.
Smaller businesses are exempt. Companies averaging $32 million or less in gross receipts over the prior three-year period escape the 163(j) cap for 2026 and can deduct interest without limitation. Larger and capital-intensive borrowers need to model the cap before assuming the full tax benefit will show up.
Lenders Take Less Risk, So They Charge Less
The tax shield explains the after-tax gap. But even before tax effects, the stated rate on debt sits well below what shareholders expect, because lending to a company is fundamentally safer than owning a piece of it.
Fixed, Contractual Payments
A borrower signs a legal contract to pay a set rate on a set schedule and return the principal at maturity. A bondholder with a 10-year corporate bond at 5% collects the same coupon whether the company has a banner year or barely breaks even. Shareholders have no such promise. Their returns depend on how the business performs and what the board chooses to pay out.
Priority in Bankruptcy
The most important protection for lenders is where they stand when things go wrong. Section 507 of the Bankruptcy Code sets a strict priority order, placing secured creditors, administrative expenses, employee wages, and tax obligations ahead of general unsecured claims.5Office of the Law Revision Counsel. 11 US Code 507 – Priorities Section 726 governs distribution in a liquidation, and equity holders receive nothing until every class of creditor claim has been paid.6Office of the Law Revision Counsel. 11 US Code 726 – Distribution of Property of the Estate
In practice, lenders often recover a meaningful share of their investment even in bankruptcy, while shareholders are frequently wiped out. Because lenders can count on some recovery in a worst case, they don’t need to charge much for default risk.
Collateral and Covenants
Two further mechanisms shrink lender risk in ways equity investors can’t match. Many loans are backed by collateral: specific assets the lender can seize on default. And loan agreements typically include covenants, contractual restrictions on how the borrower can operate. Common covenants require minimum financial ratios, cap additional borrowing, restrict dividends to shareholders, and sometimes require lender approval for major acquisitions. A covenant breach lets the lender demand immediate repayment. These protections compress the risk premium lenders need to charge.
Shareholders Take More Risk, So They Demand More
Equity sits at the opposite end of the risk spectrum, and its cost reflects that. Every feature of equity that gives the company flexibility puts more risk on the investor.
Last in Line for Everything
Shareholders are residual claimants. They receive returns only after operating costs, wages, taxes, and every dollar owed to every class of creditor. In most corporate liquidations, they receive nothing. That residual position means they absorb losses first and profit last, and they price their capital accordingly.
No Maturity, No Guaranteed Payouts
Debt has a built-in exit. A bond matures, the lender gets the principal back, the relationship ends. Common stock has no maturity date. Capital committed to shares stays committed for as long as the investor holds them, exposed to whatever happens to the company and the market.
Dividends are equally uncertain. A board can cut or eliminate them at any time without triggering a default. A missed interest payment, by contrast, is a default and can push a company into bankruptcy. Permanent commitment paired with discretionary returns forces equity investors to set a high bar.
The Risk Premium
Financial models quantify the gap through the equity risk premium: the extra return shareholders demand above the risk-free rate (typically the yield on U.S. Treasury bonds) for bearing the uncertainty of stock ownership. However it’s estimated, the resulting cost of equity almost always exceeds the after-tax cost of debt by a wide margin.
The Information Gap Makes Equity Costlier to Issue
Company insiders know more about the business than outside investors, and that gap changes how new securities get priced. When a company announces a stock offering, investors wonder why management is selling equity rather than borrowing, and a natural worry is that management thinks the stock is overvalued. Investors discount the offering price to protect themselves, which raises the effective cost of the raise.
This is the basis of the pecking order theory developed by Stewart Myers and Nicholas Majluf in 1984. Companies prefer to fund investments from internal cash flow first, then debt, and turn to new equity only as a last resort, because each step involves more information asymmetry and higher cost.7ScienceDirect. The Pecking Order, Debt Capacity, and Information Asymmetry The pattern holds in practice. Profitable companies carry significant debt because moderate borrowing is genuinely cheaper, and they avoid new equity unless they have to.
Issuance costs push in the same direction. Underwriting, legal, and regulatory fees for a stock offering are substantially higher than for a debt issue. Flotation costs on debt and preferred stock are often under 1% of the amount raised, while equity flotation costs are large enough that finance professionals routinely fold them into cost-of-equity calculations.
The Point Where Debt Stops Being Cheaper
All of this might suggest a company should fund itself entirely with debt. It shouldn’t, because debt’s cost advantage erodes and eventually reverses as leverage climbs.
Each additional dollar of debt raises the chance the company can’t meet its fixed obligations. Lenders see it and charge higher rates. At moderate leverage, the tax savings from interest deductions more than offset those higher rates. As debt keeps climbing, the risk of financial distress starts to dominate. Direct distress costs include legal and restructuring fees. The indirect ones are often worse: key employees leave, suppliers tighten credit terms, customers move to more stable competitors, and management spends its time negotiating with creditors instead of running the business.
Lenders also tighten covenants on heavily leveraged borrowers, restricting investment, acquisitions, and dividends. Those restrictions can block profitable opportunities. At some point, the cost of the next dollar of debt, including higher rates, tighter covenants, and rising distress risk, exceeds the cost of equity. The company’s overall cost of capital, which had been falling as it added tax-efficient debt, starts rising again.
That’s the core of the trade-off theory of capital structure. Every company has an optimal debt-to-equity ratio where the marginal tax benefit of another dollar of debt exactly equals the marginal increase in expected distress costs. Below that point, debt really is cheaper. Above it, the borrowing turns into a problem.