Can you answer this IB interview question?

Which is cheaper to raise capital, debt or equity, and why?

Debt is cheaper than equity because interest payments are tax-deductible, reducing the after-tax cost, and debtholders hold senior claims with contractual cash flows, so they bear less risk and accept a lower required return.

Intuition

Debt holders get paid first and have contractual protections, so they bear less risk and accept lower returns. On top of that, governments subsidize debt by making interest tax-deductible, further reducing its effective cost. Equity holders, as residual claimants who get paid last, demand a premium for absorbing all the downside risk.

Watch

A common follow-up is: 'If debt is cheaper, why not use 100% debt?' The answer is that beyond a certain level, additional debt increases financial distress risk, raising both the cost of debt and equity (per Modigliani-Miller with distress costs), so there is an optimal capital structure that balances the tax shield benefit against distress costs and loss of financial flexibility.

Deep Dive

Determine whether debt or equity is the cheaper source of capital and explain the structural reasons why.

Answer: Debt is cheaper than equity.

Three reinforcing reasons, each building on the last:

1. Tax Shield (the arithmetic reason)

Interest expense is tax-deductible; dividends / retained earnings are not.

After-tax cost of debt: $k_{d} \times (1 - t)$

Example: 6% coupon, 25% tax rate → after-tax cost = $0.06 \times (1 - 0.25) = 4.5%$

Equity has no equivalent deduction, so its full cost hits the firm.

2. Priority of Claims (the risk reason)

In liquidation, the capital-structure waterfall pays out:

Priority	Claimant	Recovery Risk
1st	Secured debt	Lowest
2nd	Unsecured debt	Low–Medium
3rd	Subordinated debt	Medium
4th	Preferred equity	High
5th	Common equity	Highest

Because debtholders sit above equityholders, they bear less risk → they accept a lower required return.

Equity is a residual claim: equityholders only get what is left after all debt obligations are satisfied.

3. Contractual vs. Residual Cash Flows (the return-expectation reason)

Debt: fixed, contractual coupons + principal repayment → predictable cash flows → lower required yield.

Equity: uncertain dividends + capital appreciation → investors demand a higher return to compensate for that uncertainty.

This shows up formally in CAPM vs. yield-to-maturity:

k_{e} = r_{f} + β \times (r_{m} - r_{f})

k_{d} = YTM on the firm’s bonds

The equity risk premium $β \times (r_{m} - r_{f})$ almost always pushes $k_{e}$ well above $k_{d}$ .

Illustrative: if $r_{f} = 4%, β = 1.1, ERP = 6%$ → $k_{e} = 4% + 6.6% = 10.6%$ , versus after-tax $k_{d}$ of 4.5% from Step 1.

Putting it together in WACC:

WACC = \frac{D}{D + E} \times k_{d} \times (1 - t) + \frac{E}{D + E} \times k_{e}

Adding more debt (up to a point) lowers WACC precisely because $k_{d} (1 - t) < k_{e}$ .

Beyond an optimal leverage point, financial distress costs rise and offset the benefit, but the per-unit cost of debt remains below equity.

Shortcut: Tax deductibility + senior claim = lower risk to the investor = lower required return. That is the entire answer in one sentence.