Debt vs Equity Financing: How Companies Choose | Interview Guide

Key takeaways

Debt is almost always cheaper than equity: interest is tax-deductible, and lenders accept lower returns than equity investors because they have priority in liquidation
The constraint on debt is not cost but capacity. The question is how much debt the company can service in a downside scenario without breaching covenants.
Interviewers test this as "when would a company issue debt vs equity?" The answer requires understanding the tax shield, credit metrics, and scenario analysis.
The optimal capital structure is the maximum amount of debt the company can support while maintaining investment-grade credit metrics in a reasonable downside case

Why Debt Is Cheaper Than Equity

Two structural reasons make debt less expensive than equity in nearly every scenario:

1. The tax shield. Interest expense is tax-deductible. If a company pays 5% interest on £100M of debt, the pre-tax cost is £5M but the after-tax cost is only £3.75M (at a 25% tax rate). Dividends to equity holders are not deductible. This asymmetry means debt financing provides a direct tax benefit that equity does not.

2. Lower required returns. Debt holders accept lower returns than equity investors because they have priority in liquidation and receive contractual interest payments regardless of the company's performance. An investment-grade lender might accept 4-6% returns. Equity investors demand 10-15%+ because they bear the residual risk and have no guaranteed payments.

4-6% vs 10-15% Typical cost of debt vs cost of equity for an investment-grade company. The gap narrows for riskier businesses and widens for stable ones.

Why Companies Do Not Use 100% Debt

If debt is cheaper, why not finance entirely with debt? Because lenders impose constraints that limit how much a company can borrow:

Constraint	Typical Threshold	What It Means
Debt / EBITDA	Below 3x for investment grade; 4-6x for leveraged	Total debt cannot exceed this multiple of annual operating cash flow
Interest coverage (EBITDA / Interest)	Above 2.5-3x for investment grade	The company must earn enough to cover interest payments with a margin of safety
Debt service coverage (DSCR)	Above 1.2-1.5x	Cash flow after capex and taxes must cover both interest and principal repayment
Fixed charge coverage	Above 1.1x for ABL facilities	Cash flow covers all fixed obligations including rent and lease payments

Exceeding these thresholds triggers covenant breaches. A breach does not mean immediate default, but it gives lenders the right to accelerate the debt (demand immediate repayment), charge penalty fees, or impose new restrictions. The company loses control of its capital allocation.

The Decision Framework: Four Steps

When a company needs to raise capital, the analytical process is:

Step 1: Model the operating scenarios. Build a base case, a downside case (revenue falls 10-15%, margins compress), and an extreme downside (revenue falls 25%+, margins compress significantly). These are the scenarios the lender will stress-test.

Step 2: Determine maximum debt capacity. In the downside case, how much debt can the company carry while staying within covenant thresholds? This is the ceiling, not the target. Most companies borrow below the ceiling to maintain a buffer.

Step 3: Evaluate debt structures. If a standard term loan does not work (amortisation payments too high in the downside), consider alternatives: subordinated notes (interest only, no principal repayment), PIK debt (interest accretes rather than being paid in cash), or convertible debt (lower coupon in exchange for equity conversion option).

Step 4: Fill the remainder with equity. If the full amount cannot be raised as debt without breaching covenants, the gap is funded with equity. The optimal mix is the maximum debt the company can safely support, with equity covering the rest.

When Equity Is Actually the Right Choice

Debt is cheaper on paper, but there are situations where equity is the better financing decision:

High-growth, pre-profit companies. A company with negative EBITDA cannot service debt. Revenue-stage tech companies, biotech firms pre-FDA approval, and early-stage businesses have no choice but to issue equity.
Highly cyclical businesses. Companies with volatile cash flows (airlines, commodity producers, homebuilders) risk covenant breaches in downturns. Lower leverage protects against this, even though it increases the average cost of capital.
Acquisitions where the seller demands certainty. Equity-financed offers carry no financing condition. A bidder offering cash funded by equity can guarantee closing, whereas a debt-financed offer depends on syndication. In competitive auctions, this certainty has value.
When the stock is overvalued. If management believes the share price is above intrinsic value, issuing equity is economically rational. The company raises capital at an inflated price, diluting existing shareholders less than if the stock were fairly valued. This is rarely stated publicly but frequently motivates equity issuance.

The Interview Question: "When Would a Company Issue Debt vs Equity?"

Model answer "Debt is almost always cheaper than equity because interest is tax-deductible and lenders accept lower returns due to their priority in liquidation. So the default financing choice is debt. The constraint is capacity: the company can only borrow as much as it can service in a downside scenario without breaching credit covenants like debt/EBITDA and interest coverage thresholds. A company would choose equity when it cannot support additional debt (leverage already high, or cash flows too volatile), when it is pre-profit and has no cash flow to service interest, or when it wants to offer certainty of closing in a competitive M&A process. In practice, most financing decisions result in a mix of debt and equity, optimised to minimise WACC while maintaining an acceptable credit profile."

Common Follow-Up Questions

"What happens to WACC as you add more debt?"

WACC initially decreases because you are replacing expensive equity with cheaper debt. But beyond a certain point, the cost of debt rises (lenders demand higher rates for riskier capital structures), the cost of equity rises (equity holders demand more return to compensate for increased financial risk), and the tax shield benefit plateaus. WACC reaches a minimum at the optimal capital structure and then increases. This is the core insight of the Modigliani-Miller framework with taxes.

"How does issuing debt affect EPS?"

Debt increases interest expense, which reduces net income. But because no new shares are issued, the share count stays the same. The effect on EPS depends on whether the after-tax cost of the new debt is lower than the earnings yield on the proceeds. If the company borrows at 4% after-tax and invests in a project earning 10%, EPS increases despite the higher interest expense.

"How does issuing equity affect EPS?"

New shares are issued, increasing the denominator. If the proceeds are invested in something that earns more than the current EPS yield, EPS rises (accretive). If not, EPS falls (dilutive). Most equity issuances are dilutive in the near term because the capital takes time to generate returns.

"A company has 2x debt/EBITDA and wants to acquire a target for 3x its own EBITDA. Should it use debt or equity?"

After the acquisition, pro forma leverage would be roughly 5x (existing debt + acquisition debt, divided by combined EBITDA). 5x is at the upper end of leveraged territory. Whether this works depends on the combined company's cash flow stability, the acquirer's existing covenant headroom, and the target's margin profile. A stable, high-margin combined business might support 5x; a cyclical one probably cannot. The answer is "it depends on the downside cash flow scenario" followed by the specific factors that determine debt capacity.

The Three-Statement Impact

Understanding how debt and equity issuance flow through the three statements is tested frequently:

Event	Income Statement	Balance Sheet	Cash Flow Statement
Issue £100M debt	Interest expense increases (ongoing)	Cash +£100M, Debt +£100M	Financing inflow +£100M
Issue £100M equity	No immediate impact	Cash +£100M, Equity +£100M	Financing inflow +£100M
Repay £50M debt	Interest expense decreases (ongoing)	Cash -£50M, Debt -£50M	Financing outflow -£50M
Buy back £50M shares	No direct impact (EPS increases due to fewer shares)	Cash -£50M, Equity -£50M	Financing outflow -£50M

Take Your Preparation Further

Download our free Valuation Cheat Sheet for the complete WACC build-up, capital structure weights, and cost of debt/equity calculations. For comprehensive interview preparation, see the IB Interview Bible.

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Debt vs Equity: How Companies Choose and How Interviewers Test It