Equity is cheaper than debt, isn't it?
Is equity really the most expensive source of funds in a companies capital structure? By looking at historical dividend payouts from Apple, Microsoft etc, it seems as if their dividend yield would always 2%.
How's that more expensive than any debt instrument?
You should compare the total returns of an equity investment (i.e. Dividends + Capital Gains) with the costs of debt.
if you watch shark tank (which you should) you would have learned that for a startup, equity is more expensive than debt for the founder to sell IF THE COMPANY WILL GROW EXPONENTIALLY.
So, imagine your small company had 100k in sales (revenue) on 20k in costs, for a total profit of 80k. Imagine that you could scale that business to 1 billion in sales, at the same cost ratio, so 200mm in costs, for a total profit of 800mm.
Imagine you need 1 million dollars to get the scale going, and you as the founder/owner have 2 choices 1 - give up 40% of the equity for that 1mm 2 - borrow 1mm for 20% annual interest, repayable within 5 years
If you can scale up to 10mm in sales within 1 year, thus profiting 8mm minus your debt...and then keep up scaling....the total vale of your equity will be higher, than if you gave up 40% of your equity for that 1mm equity stake
Do the math
under the equity sale, and our 10mm revenue projection 40% of 8mm = 3.2mm (this is given to your new shark investor) leaving you 4.8mm
or 20% interest on 1mm = 200k, after which you buy back/retire that debt (so, your 8mm profit becomes 6.8mm, (and you are now debt free)
which scenario do you choose?
Who hurt you?
no one is saying anything about the tax deductability of debt?
Why add further to the confusion. We're dealing with an OP that doesn't get why debt is cheaper than equity. We don't need any heads exploding.
hahaha but isn't this the fundamental argument for debt > equity (cheaper)?
I would say the tax treatment is the icing on the cake. Debt would be cheaper regardless because it is less risky (debtholders get paid first). The tax break does make it even cheaper though.