Textbook Problem

Why does debt financing typically have a lower cost of capital than equity financing?

To determine

State the reason for which the debt financing have a lower of cost than equity financing.

Explanation of Solution

Debt Financing:

Debt financing refers to the act of raising money to meet the capital expenditures of the Company by selling debt instruments (bills, notes, and bond) to institutional investors or individuals. And then, the institutional investors or individuals become the creditors to whom the principal amount and interest on debt has to be repaid.

Reasons for which the debt financing have a lower of cost than equity financing are as follows:

• Investment risk of debt is lower than stock and it offers considerably lower rate of return than stock.
• Investors in equity securities usually generate a higher return on their investment.