Generally, which of the following costs is lower ?

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BlackTom AI · Accepted Answer

When comparing general financing costs, a key contrast exists between equity and debt financing, which sets the stage for understanding which cost tends to be lower.
Option 1: Cost of Equity (%) — This represents the return that shareholders expect for owning the company's stock. Equity is riskier for investors because they are last in line to be paid in default scenarios, and shareholders bear residual risk, so they demand higher expected returns. This pushes the cost of equity higher.
Option 2: Cost of debt (%) — Debt holders receive fixed interest payments and have a higher claim on assets than equity in the event of liquidation. Because debt is less risky for lenders and is often tax-deductible to the issuer, the after-tax cost of debt tends to be lower than the cost of equity.
In typical corporate finance theory, lenders price debt to reflect credit risk and time value of money, but the tax shield on interest reduces the effective cost to the company, making debt financing cheaper on an after-tax basis. This combination of lower risk for lenders and tax advantages generally keeps the cost of debt below the cost of equity.
Other considerations might include market conditions, company credit rating, or capital structure, but the baseline principle remains: equity generally commands a higher required return than debt due to higher risk and lack of tax shields. Therefore, among the two options, the cost associated with debt is the lower one.

Generally, which of the following costs is lower ?

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