Question

Explain why debt is usually considered the cheapest source of financing available?

Answer 1

Debt financing is one of the most cheaper sources of arranging funds.

One of the biggest reasons is the tax benefits you get on the interest part paid to your lender. It reduces the tax burden on the taxpayer.

Creditors cannot claim the assets of a firm which is less risky when a company is winding up.

Lender cannot ask for a share in profits which reduces the amount paid out of creditors.

Answer 2

since leaders earn on assured returns and payment of capital, the risk is lower than risk of equity share holders.

As a result lenders require a lower rate of return as compared to equity share holders.

Further interest on debt is a deductible expense for computation of tax liability, whereas, dividend on equity are paid out of after- tax profit.

Therefore increased use of debt lowers the overal cost of capital if cost of equity remains unaffected.

hope it will help you