Can you answer this IB interview question?

Why would a company issue debt or equity? What are the pros and cons of each?

Debt is often cheaper and avoids ownership dilution, but creates required interest/principal payments, covenants, and bankruptcy risk. Equity is more flexible and has no required repayment, but dilutes ownership and is usually more expensive.

Intuition

Debt and equity allocate risk and control differently: debt gives investors a contractual, senior claim, while equity absorbs residual uncertainty and therefore demands higher returns and governance rights. The financing choice is really about who bears operating risk and how much fixed obligation the business can safely layer on before flexibility is outweighed by distress risk. Capital structure balances the cheapness of senior, tax-advantaged capital against the rising fragility of making obligations less contingent on performance.

Watch

Expect a follow-up on WACC and optimal capital structure — be ready to explain why adding debt initially lowers WACC but eventually raises it as bankruptcy risk pushes both r_d and r_e higher.

Deep Dive

Explain the strategic rationale and trade-offs for a company choosing to raise capital via debt versus equity.

Why issue capital: fund growth (M&A, capex, R&D), refinance, shore up liquidity, or return capital (levered recaps).

Debt vs. Equity — Side-by-Side:

Dimension	Debt	Equity
Cost of capital	Lower — senior claim; interest tax-deductible, after-tax cost = $r_{d} \times (1 - t)$	Higher — residual claim, $r_{e} > r_{d}$
Dilution	None — no voting/equity stake	Direct dilution of ownership and EPS
Tax shield	Interest deductible: savings = $Interest \times t$	Dividends not deductible; no shield
Repayment	Mandatory principal and interest	No mandatory repayment; dividends discretionary
Bankruptcy risk	Missed payments trigger default	No incremental default risk; permanent capital
Flexibility	Covenants restrict actions (leverage, RPs, liens)	No covenants; max flexibility
Near-term EPS	Accretive if after-tax cost < earnings yield on proceeds	Dilutive — share count rises
Signal	Confidence in cash flow	Often negative — stock may be overvalued
Credit rating	Added leverage may pressure rating	Strengthens balance sheet

Lean toward debt when:

Stable, predictable cash flows

Strong asset base for collateral

Meaningful tax rate (maximizes tax shield)

Stock is undervalued

Existing leverage is low vs. peers / rating capacity

Lean toward equity when:

High existing leverage (near covenants or downgrade)

Volatile or early-stage cash flows

Stock trading at premium valuation

Need maximum flexibility (e.g., M&A pipeline)

Lenders unwilling to extend credit (distressed / pre-revenue)

Unifying framework — WACC:

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

Adding debt initially lowers WACC because $r_{d} (1 - t) < r_{e}$ . Beyond an optimal point, rising bankruptcy risk pushes both $r_{d}$ and $r_{e}$ higher, and WACC rises. Optimal capital structure minimizes WACC.

Shortcut: Debt is cheaper but riskier to the firm; equity is more expensive but safer. The choice reduces to: can cash flows reliably handle the fixed burden of debt, and is the stock fairly valued?