Question

Debt is a cheaper source of financing than equity because

Group of answer choices

equityholders face greater risk than creditors because of the residual nature of their claim, and they expect a higher return as compensation.

interest on debt is tax deductible, but returns to owners are not.

All of these are correct.

debt is tax deductible, which reduces the effective cost of borrowing.

Two of these are correct.

Answer 1

Answer - Two of these are correct.

First correct statement - equityholders face greater risk than creditors because of the residual nature of their claim, and they expect a higher return as compensation. Equity holders have the last claim on the assets in case of a bankruptcy event, and hence face a higher risk of capital loss than the debt investors, which implies higher risk. Higher risk demands higher return as compensation.

Second correct statement - interest on debt is tax deductible, but returns to owners are not. Interest on debt is tax deductible. This implies it reduces the tax bill of the issuer. However, dividend payments to stockholders are not tax deductible. Hence, the cost of debt is lowered by the tax rate.

Incorrect statement - debt is tax deductible, which reduces the effective cost of borrowing. Debt in itself is not tax deductible. Only interest payments on the debt are tax deductible and reduce the cost of debt.