Why is debt cheaper than equity, and what's the tradeoff?

Q: What is the debt seniority hierarchy in bankruptcy?

The hierarchy from first paid to last: (1) Senior Secured—first claim, backed by specific collateral like real estate or equipment; (2) Senior Unsecured—first claim but no collateral; (3) Subordinated/Junior—paid only after senior debt is satisfied; (4) Mezzanine—hybrid between debt and equity, often with warrants attached. Higher seniority means lower risk and lower interest rates.

Q: Why is debt cheaper than equity for a company?

Debt is cheaper for two reasons. First, priority: lenders accept lower returns because they have contractual claims and get paid before equity holders, making their investment less risky. Second, the tax shield: interest expense is tax-deductible while dividends are not, reducing the effective cost of debt by the company's tax rate.

Q: What are debt covenants and why do they matter?

Covenants are contractual restrictions lenders impose to protect their downside. Maintenance covenants must be met continuously (e.g., Debt/EBITDA below a threshold). Incurrence covenants only apply when taking specific actions like issuing more debt. Breaching covenants can trigger default, giving lenders the right to accelerate repayment or seize control.

Q: What is the difference between fixed-rate and floating-rate debt?

Fixed-rate debt locks in a constant interest rate for the life of the loan, providing payment certainty. Floating-rate debt resets periodically based on a benchmark rate like SOFR plus a credit spread. Floating-rate borrowers benefit when rates fall but face higher costs when rates rise. Most leveraged loans use floating rates.

What debt is, how it works in corporate finance, and why lenders have priority over shareholders in the capital structure.

OfferGoblin·5 min read··

"Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery." — Charles Dickens, David Copperfield

Concept

Debt is borrowed capital that must be repaid with interest. Unlike equity, debt holders have a contractual claim to specific payments regardless of company performance. If a company misses a debt payment, creditors can force bankruptcy and seize assets. This priority makes debt cheaper than equity—but that cheapness comes with covenants, schedules, and the ever-present risk of default.

Intuition

Debt exists because lenders accept lower returns in exchange for contractual certainty. Equity holders take unlimited upside but can lose everything. Debt holders cap their upside at the interest rate but get paid first.

From a company's perspective, debt is cheaper than equity for two reasons:

Priority: Less risky for investors, so they demand lower returns
Tax Shield: Interest is deductible; dividends are not

The catch: debt is unforgiving. Miss a payment, breach a covenant, or face a downturn at the wrong time, and creditors take control. Equity investors can wait out bad years. Debt holders don't have to.

Components

Principal and Interest

What It Is

Principal is the original amount borrowed. Interest is the cost of borrowing, expressed as a rate applied to principal.

How to Calculate It

Interest Expense = Principal \times Interest Rate

A $100M loan at 8% annual interest costs $8M per year.

Key Consideration

Interest is tax-deductible, reducing the effective cost. At a 25% tax rate, that $8M interest expense only costs $6M after the tax shield.

Seniority and Security

What It Is

Seniority determines who gets paid first in bankruptcy. Security refers to whether debt is backed by specific collateral.

The Hierarchy

Senior Secured: First claim, backed by assets (real estate, equipment, inventory)
Senior Unsecured: First claim, no collateral
Subordinated/Junior: Gets paid only after senior debt is satisfied
Mezzanine: Hybrid between debt and equity, often with warrants attached

Key Consideration

Higher seniority = lower risk = lower interest rate. A senior secured loan might price at SOFR + 200bps while subordinated debt prices at SOFR + 600bps for the same company.

Covenants

What It Is

Covenants are contractual restrictions lenders impose to protect their downside. They limit what borrowers can do with the money and require maintaining certain financial metrics.

Types

Maintenance Covenants: Must be met continuously (Debt/EBITDA under 4.0x, Interest Coverage above 2.0x)
Incurrence Covenants: Only tested when taking specific actions (issuing new debt, paying dividends)
Negative Covenants: Prohibitions (no asset sales above $10M without consent, no additional liens)

Key Consideration

Violating a covenant triggers technical default, even if you're current on payments. This gives lenders leverage to renegotiate terms, raise rates, or accelerate repayment.

Fixed vs. Floating Rate

What It Is

Fixed-rate debt locks in an interest rate for the life of the loan. Floating-rate debt resets periodically based on a benchmark (SOFR, Prime).

The Trade-off

Type	Upside	Downside
Fixed	Predictable payments, protected if rates rise	Locked in if rates fall, often higher initial rate
Floating	Lower initial rate, benefits if rates drop	Exposed to rate increases, harder to budget

Key Consideration

Floating-rate debt is often expressed as SOFR + spread. SOFR + 300bps means if SOFR is 5%, you pay 8%.

Amortization vs. Bullet

What It Is

Amortizing debt requires periodic principal payments throughout the loan term. Bullet debt (or term loans with bullet maturities) requires principal only at maturity.

Cash Flow Impact

Amortizing: Steady cash drain, lower refinancing risk, reduces leverage over time
Bullet: Preserves cash for operations, but creates a "maturity wall" requiring refinancing or a large lump-sum payment

Key Consideration

Bonds are almost always bullet structures. Term loans typically have some mandatory amortization (often 1% per year) with the remainder due at maturity.

Interview Script

Debt is borrowed capital that must be repaid with interest, where lenders have a contractual claim to specific payments regardless of company performance. It's cheaper than equity for two reasons: debt holders accept lower returns because they get paid first in the capital structure, and interest payments are tax-deductible unlike dividends. The tradeoff is that debt is unforgiving—miss a payment or breach a covenant, and creditors can force bankruptcy and seize assets.

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Frequently Asked Questions

What is the debt seniority hierarchy in bankruptcy?

Why is debt cheaper than equity for a company?

What are debt covenants and why do they matter?

What is the difference between fixed-rate and floating-rate debt?