What is a primary reason debt is considered cheaper than equity?

Debt is considered cheaper than equity primarily because debtholders receive their returns before equity holders. This seniority in the capital structure means that in the event of liquidation or bankruptcy, creditors have a priority claim on assets. As a result, the risk associated with lending is lower compared to the risk faced by equity investors, who are last in line to receive any payouts.

This perceived lower risk translates into lower required returns for debtholders, making debt a cheaper source of financing. Furthermore, the interest payments on debt are often tax-deductible, adding to its attractiveness and reducing the overall cost of capital for the company.

In contrast, while equity investors typically expect higher returns due to taking on more risk (including the risk of total loss if the company fails), the fact that equity investors are last to be compensated in bankruptcies highlights their higher risk and cost. Other options, such as debt having no associated interest expenses or debt promising higher returns to investors, do not accurately capture the fundamental reason why debt is cheaper; they misrepresent how the structure and returns of debt work in the financial landscape.