Raising Capital: Debt, Equity and What Each Costs
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In short
A company that needs more capital than it generates has two places to get it: lenders and shareholders.
Scope. This article explains the two sources of external capital, what each costs, and what each obliges a company to do. It does not say what mix a company should have — weighting the sources into a single blended cost of capital is the subject of the next article in this pillar. No threshold is given for any leverage or coverage measure, and no financing decision is characterised as prudent or reckless. Worked figures are the portal's fictional company.
Everything else — bank facilities, bonds, convertibles, leases, rights issues, private placements — is a variation on one of those two, or a hybrid built from both.
The distinction that matters is not the price. It is the nature of the claim. A lender has a contract: fixed amounts on fixed dates, enforceable, and ranking ahead of shareholders. A shareholder has a residual: whatever is left, whenever the company chooses to distribute it, ranking last. Every difference in cost, behaviour and consequence follows from that.
What each costs, for the canonical company
Using Wexford Instruments and the Pillar 22 parameter set.
| Source | Basis | Cost |
|---|---|---|
| Debt, before tax | interest 18.0 over average debt 350.0 | 5.14% |
| Debt, after tax | 5.14% less the 24.0% effective tax rate | 3.91% |
| Equity | risk-free 4.0% plus a market beta of 1.00 on an equity risk premium of 5.0% | 9.00% |
| Difference | equity less after-tax debt | 5.09 percentage points |
Worked example
Worked example — why debt is cheaper, and why that is not a free lunch. Debt costs 3.91% after tax against 9.00% for equity, a gap of 5.09 percentage points, and two things create it. Seniority: a lender is paid first and can enforce, so the lender bears less risk and requires less return — the discount is compensation for a better position, not a mispricing. Deductibility: interest reduces taxable profit while dividends do not, so part of the cost is borne by the tax authority. For this company the shield is 18.0 of interest at 24.0%, or 4.32 — equal to 6.9% of net income. The reason it is not free is that the two claims are not independent. Adding debt does not leave the cost of equity where it was: the residual claim becomes more volatile as fixed obligations rise ahead of it, so shareholders require more. How much more, and whether the shield outweighs it, is the subject of the next article — this one establishes only that the raw comparison of 3.91% against 9.00% is not the whole calculation.
What each source obliges the company to do
Debt creates fixed commitments. Interest and principal are owed on dates set in advance, regardless of what the business earns. That certainty is the whole point for the lender and the whole risk for the borrower. Covenants add a second layer: conditions the company must maintain, breach of which can accelerate repayment. Debt therefore constrains the future in ways an income statement does not show, which is why the debt note in the filings carries more information than the balance-sheet line.
Equity creates no obligation at all. Dividends are discretionary, there is no maturity, and a bad year requires no payment to anyone. What it creates instead is permanent dilution of ownership — a new shareholder's claim on all future profits does not expire when a loan would have been repaid.
That asymmetry is the trade. Debt is cheaper and rigid; equity is expensive and forgiving. A company choosing between them is choosing between a lower cost and a wider margin for error, and the correct choice depends on how predictable its cash flows are — which is a fact about the business rather than about finance.
Dilution, computed
Dilution is arithmetic, and separating it from its effects is worth doing carefully. Wexford raised no equity this year, so the illustration below is a counterfactual using the pillar's illustrative share price of $12.00.
| Scenario | Shares | Effect on basic earnings per share |
|---|---|---|
| As reported | 100.00m | $0.623 |
| Raising 20.0 of equity at $12.00 | 101.67m | $0.613, a fall of 1.64% |
| Existing dilutive instruments, if all converted | 103.00m | $0.605, a fall of 2.89% |
Worked example — what the dilution arithmetic does and does not show. A 20.0 equity raise at the illustrative price adds 1.67m shares and reduces earnings per share by 1.64%, holding earnings constant. Holding earnings constant is the assumption doing all the work. The company raised the capital in order to do something with it, and whatever that is will change the numerator — so an earnings-per-share calculation that dilutes the denominator while freezing the numerator describes an event that never happens. The dilution is real and the comparison is incomplete, which is why per-share arithmetic is a starting point for the question rather than an answer to it. The same caution applies to repurchases in reverse: reducing the share count raises per-share figures without changing the business.
The forms each source takes
Debt: bank term loans and revolving facilities; publicly issued bonds; private placements; leases, which are contractual obligations to pay for the use of an asset and appear on the balance sheet accordingly; and convertible instruments, which begin as debt and may end as equity.
Equity: an initial public offering; a follow-on offering; a rights issue, which offers existing holders the chance to subscribe proportionally and so avoid dilution; an at-the-market programme, which sells shares gradually into the market; private placements; and shares issued to employees as compensation, which is a capital raise in substance even though no cash arrives.
That last one is worth pausing on. Stock-based compensation is a real cost recorded in operating expenses and a real issuance of ownership, and it appears as a non-cash add-back in the cash-flow statement — Pillar 23's article on it works the arithmetic on a charge of 15.0 for a company of Wexford's scale. It is the only form of capital raising that most readers never think of as one.
Frequently asked
8 questions
What are the two sources of external capital?
Lenders and shareholders. Everything else — bank facilities, bonds, convertibles, leases, rights issues — is a variation on one of them or a hybrid of both.
Why is debt cheaper than equity?
Seniority and deductibility. A lender is paid first and can enforce, so bears less risk and requires less return; and interest reduces taxable profit while dividends do not. In the worked example debt costs 3.91% after tax against 9.00% for equity — a gap of 5.09 percentage points.
What is the interest tax shield?
The tax saved because interest is deductible. For the canonical company, 18.0 of interest at a 24.0% effective rate saves 4.32, equal to 6.9% of net income.
If debt is cheaper, why not use only debt?
Because the two claims are not independent. Adding fixed obligations ahead of the residual claim makes that residual more volatile, so shareholders require more — the cost of equity does not stay where it was. How the two effects net out is the subject of the next article in this pillar.
What does debt oblige a company to do that equity does not?
Pay fixed amounts on fixed dates regardless of earnings, and maintain any covenant conditions, breach of which can accelerate repayment. Equity obliges nothing: dividends are discretionary and there is no maturity.
How much does an equity raise dilute?
Mechanically, 20.0 raised at the illustrative $12.00 adds 1.67m shares to 100.0m and reduces earnings per share by 1.64% — but only if earnings are held constant, which assumes the company does nothing with the money it raised. The dilution is real; the comparison is incomplete.
What is a rights issue?
An offer allowing existing shareholders to subscribe proportionally, which lets them maintain their ownership percentage and so avoid dilution if they take it up.
Is stock-based compensation a form of raising capital?
In substance, yes. Shares issued to employees are a real cost recorded in operating expenses and a real issuance of ownership, appearing as a non-cash add-back in the cash-flow statement. It is the form of capital raising most readers never think of as one.
References
- Investor.gov (SEC) — How to Read Financial Statements —
- SEC — Investor Bulletin: How to Read a 10-K —
- Investor.gov (SEC) — Dilution —
Educational and informational only — not investment advice, a recommendation, or an offer to buy or sell any security. Investing involves risk, including the possible loss of principal. Worked examples use fictional companies and figures.