Cost of Equity vs Cost of Debt: Why Equity Costs More

Cost of equity is higher than cost of debt because shareholders take more risk. Lenders get a fixed interest payment and are paid first. Shareholders get whatever is left after everyone else is paid, and they may get nothing. On top of that, interest is tax deductible for the company and dividends are not. In the site’s example, equity costs 11% while debt costs 6% before tax and 4.74% after the 21% federal tax deduction.

You can calculate the equity side with the cost of equity calculator. This guide explains why the two rates differ and how they compare in practice.

Side by side

	Cost of equity	Cost of debt
Who it pays	Shareholders	Lenders and bondholders
What they receive	Dividends and price gains, not guaranteed	Fixed interest and repayment of principal
Order of payment	Last (residual claim)	Before shareholders
In bankruptcy	Paid only if anything is left	Paid ahead of shareholders
Tax treatment for the company	Dividends not deductible	Interest deductible
Observable?	No, must be estimated	Mostly, from loan rates and bond yields
Common estimate methods	CAPM, dividend growth model, build-up	Bond yield, loan rate, rating spread
Site example	11%	6% pre-tax, 4.74% after tax

Reason 1: shareholders are paid last

A company’s cash goes to suppliers, employees, the tax authority and lenders before shareholders see any of it. Shareholders hold what’s called the residual claim. They own whatever’s left.

In a good year, that leftover can be large. In a bad year, it can be zero or negative. If the company fails, lenders are paid from what remains and shareholders often lose everything.

That uncertainty is what investors charge for. A lender with a fixed claim and first place in line needs less return than an owner with an uncertain claim at the back of the line. The more volatile the leftover, the higher the required rate of return.

Reason 2: the tax deduction on interest

In the US, a company can deduct interest from taxable income. It can’t deduct dividends. So a dollar of interest costs the company less than a dollar.

Take the site’s example: $400 of debt at 6%.

• Annual interest: $400 x 6% = $24.
• Tax saved at 21%: $24 x 0.21 = $5.04.
• Net cost after tax: $24 - $5.04 = $18.96.
• After-tax cost of debt: $18.96 / $400 = 4.74%.

Now the equity side: $600 of equity at an 11% cost of equity means shareholders expect $66 a year in dividends and share price gains combined. There’s no deduction to soften it.

Per dollar raised, equity costs 11 cents a year and debt costs about 4.7 cents after tax.

This is why the WACC formula applies (1 - t) to the cost of debt and not to the cost of equity:

WACC = E/V x Ke + D/V x Kd x (1 - t)

The WACC guide works through the full example to 8.5%.

Reason 3: one is observed, the other estimated

This one affects how much you can trust each number.

You can often look up the cost of debt. A company’s bonds have a yield. Its bank loans have a stated rate. If neither is available, you can add a credit spread that matches its credit rating to the risk-free rate.

Cost of equity can’t be looked up. It’s an estimate built from a model like CAPM, with inputs that involve judgment. Two careful analysts can get different answers. That’s why it pays to test a range of equity risk premiums and betas before settling on one number.

How the gap changes with debt

Both costs go up as a company borrows more, but equity rises faster at first.

The cost of equity rises because shareholders now stand behind a bigger fixed claim. Their leftover gets more volatile, and beta rises. The levered vs unlevered beta guide shows this with numbers: the same business moves from a 9.50% cost of equity with no debt to 11.28% at a 0.5 debt-to-equity ratio.

The cost of debt stays fairly flat at modest debt levels, then climbs once lenders start worrying about default. At very high debt levels, lenders begin to carry equity-like risk and charge for it.

The FAQ on whether cost of equity increases with debt goes further into this.

Can cost of debt ever be higher?

For most healthy companies, no. If a company could borrow at a rate above its cost of equity, the debt would be riskier than the shares, which is backwards given who gets paid first.

You can still see odd results in practice. A distressed company’s bonds may yield more than a CAPM estimate of its cost of equity, usually because the CAPM inputs (especially a backward-looking beta) haven’t caught up with the company’s situation. When that happens, the CAPM number is the one to question. The FAQ on whether cost of equity can be less than cost of debt covers these cases.

Why it matters for decisions

The gap between the two costs affects real choices:

1. Funding. Debt looks cheaper on paper, but each extra dollar of debt raises the cost of the remaining equity and the risk of default.
2. Valuation. Using the wrong rate for the wrong cash flows inflates or deflates value. Equity cash flows get the cost of equity. Whole-firm cash flows get WACC.
3. Project approval. A project funded entirely by a new loan still has to clear a rate that reflects its risk to the whole company. The cheap loan rate is the wrong hurdle rate on its own.

Summary of the example

Measure	Value
Cost of equity (CAPM: 5% + 1.2 x 5%)	11.00%
Pre-tax cost of debt	6.00%
After-tax cost of debt (6% x 0.79)	4.74%
Gap, equity vs after-tax debt	6.26 points
WACC at 60% equity, 40% debt	8.50%

For a broader view of both costs together, see the glossary entry on cost of capital. For a plain definition of the equity side, see the FAQ on what cost of equity is.