Question

Are taxes necessary for the cost of debt financing to be less than the cost of equity financing?

I need clear answer not picture

Answer 1

Cost of debt financing is genrally considered low in comparison of financing from equity because of the fact that debts are considered less risky due to its features of priority in payment of funds in case of winding up of company and also in the payment of interest expense whether the company earned profit or incurred losses. While on the other hand equityholders do not have these two privileages due to which investment in equity is more risky and due to high degree of risk involved in equity investment, equity investords demand a higher rate of return in form of dividend which increases the cost of equity. So risk involved in debt and equity decides the cost of debt or equity.

But yes this is also one of the important factor that taxes reduces the cost of debt, because interest expense is a deductible expense under income tax provision and interest tax shield on debt reduces the cost of debt in comparison of equity.