How is the cost of debt typically compared to equity in financial decisions?

The cost of debt is typically considered to be lower than the cost of equity, which is why the first choice stands out. Debt financing is generally cheaper for several reasons. Interest payments on debt are tax-deductible, which effectively reduces the overall cost of borrowing. This is beneficial for companies that can leverage this tax shield.

Additionally, lenders typically require lower returns compared to equity investors. Equity investors take on more risk because they are last in line to receive payments; thus, they expect higher returns as compensation for assuming that risk. In contrast, creditors have a higher claim on assets in the event of liquidation and receive regular interest payments, making their investment less risky.

Consequently, when companies make financial decisions, they often find that accessing debt markets provides a less expensive form of capital compared to equity financing. This analysis plays a critical role in corporate finance strategies, including capital structure decisions and long-term financial planning.