Every business pays a price for the money it uses. That price is the cost of capital, and it determines which projects create value. Understanding debt vs equity is the foundation of corporate finance.
What Is the Cost of Capital?
It is the minimum return a company must earn on an investment to satisfy its lenders and shareholders. If a project returns less than the cost of capital, it destroys value even if it is profitable on paper.
Cost of Debt
Debt (loans, bonds) is usually cheaper than equity because interest payments are tax-deductible and lenders take less risk. The effective cost of debt = interest rate minus the tax benefit. The catch: debt is mandatory — missed payments can bankrupt a firm.
Cost of Equity
Equity (issuing shares, retained earnings) costs a lot: investors demand a return for risk and there is no tax deduction. But it is flexible — there is no obligation to pay dividends. It is typically more expensive than debt.
The Weighted Average Cost of Capital (WACC)
Companies combine both sources into the WACC — the blended rate used to discount project cash flows. A balanced capital structure lowers WACC by mixing cheaper debt with equity while keeping default risk manageable.
Choosing a Mix
Stable, cash-generating businesses can carry more debt; volatile startups usually rely more on equity. The goal is the lowest WACC the business can sustain.
FAQ
Why is debt cheaper than equity?
Because lenders take less risk, receive priority on assets, and interest is tax-deductible.
What happens if a project earns less than WACC?
It reduces shareholder value; wise companies reject it or find cheaper financing.
Related: Capital Budgeting and Income Statement Explained.