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

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, a hybrid between debt and equity, often with warrants attached. Higher seniority means lower risk and lower interest rates.

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.

Net debt to EBITDA is total debt minus cash on hand, divided by EBITDA. Read it as roughly how many years of earnings it would take to pay off all of the debt. As a rule of thumb, one to two times is conservative and four times and up is pretty aggressive. It matters because of the payment waterfall: lenders collect on the cash before shareholders do.

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.

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.