The Debt vs Equity Financing Decision

A company needs $100m to build a new factory. It can borrow the money from a bank or bondholders, promising fixed payments regardless of how the factory performs, or it can sell shares to new investors, who get no fixed promise but share in whatever profit or loss results. Both raise the same $100m. They are not remotely the same decision.

What actually differs

Debt is a contract: the company promises fixed interest payments and repayment of principal, on a schedule, regardless of how the business performs. Lenders have a senior claim — they are paid before shareholders see a cent, including in bankruptcy — but they are capped: a bondholder never gets more than the promised interest and principal, no matter how well the factory does. Interest is also tax-deductible, which lowers its true cost to the company. In the US, if the corporate tax rate is 25%, then a 6% coupon really costs the company $6\% \times (1 - 0.25) = 4.5\%$ after tax.

Equity has no fixed payment at all. Shareholders get whatever is left after every other claim is paid, which can be enormous in a good year and zero in a bad one — the exact residual-claim structure covered in balance sheet basics. Equity carries no repayment obligation and no maturity date, so it never forces bankruptcy on its own. But issuing new shares dilutes existing owners, and because equity investors are last in line and bear more risk, they demand a higher expected return than lenders — equity is structurally the more expensive form of capital.

A worked example

A company with $0 debt has 10 million shares and $50m of operating profit, all going to shareholders — earnings per share of $5.00. It needs $100m for expansion.

Debt route: borrow $100m at 6%, so pre-tax interest is $6m a year. After a 25% tax shield, the after-tax cost is $4.5m. Operating profit rises to $65m (the expansion adds $15m), interest expense reduces this to $65m − $6m = $59m pre-tax, taxed at 25% for $44.25m net income, spread over the same 10 million shares: EPS of $4.43. Risk is also higher — that $6m is owed whether the expansion succeeds or not.

Equity route: sell 2.5 million new shares at $40 each to raise the same $100m. Operating profit is again $65m with no interest expense, taxed at 25% for $48.75m net income, but now spread over 12.5 million shares: EPS of $3.90. Lower risk — nothing is owed if the expansion underperforms — but existing shareholders now own a smaller slice of a bigger pie.

In this example debt produces higher EPS because the expansion's return exceeds debt's after-tax cost — a case of leverage working in shareholders' favor. If the expansion had earned less than 4.5% after tax, debt would have lowered EPS instead, since the fixed interest cost would have exceeded what the new capital earned.

Why not just use the cheaper one every time

If debt is cheaper, why do healthy companies still issue equity at all? Because leverage is not free — it raises the probability of financial distress, and lenders and rating agencies price that in: borrow too much and the next dollar of debt costs far more than 6%, or isn't available at all. That tension between the tax benefit of debt and the rising cost of financial distress is formalized in the trade-off theory, and the pattern of which source companies actually reach for first is described by the pecking order theory.