The primary reason why debt financing is considered a cheaper source of finance compared to equity financing is due to its preferential tax treatment.

Debt Financing Cost Advantage

Debt financing offers a cost advantage primarily because the interest paid on borrowed funds is typically a tax-deductible expense. This means companies can reduce their taxable income by the amount of interest paid.

This reduction in taxable income creates a "tax shield," effectively lowering the overall cost of debt. The calculation demonstrates this:

Effective Cost of Debt = Nominal Interest Rate $\times$ (1 - Tax Rate)

For example, if a company borrows at a 10% interest rate and faces a 30% corporate tax rate, the effective cost of debt is:

Effective Cost of Debt = 10% $\times$ (1 - 0.30) = 10% $\times$ 0.70 = 7%

This 7% effective cost is significantly lower than the cost of equity, which is not tax-deductible.

Analysis of Options

• Time value of money: While fundamental to finance, it doesn't explain why debt is specifically cheaper than equity.
• Rate of interest: This is the nominal cost, but the tax deductibility significantly alters the *effective* cost, making it lower.
• Tax deductibility of interest: This is the key factor providing a direct cost reduction for debt financing. (Correct)
• Dividends are not payable to lenders: While lenders receive interest and not dividends, this is a characteristic of debt, not the direct reason for its lower cost compared to equity. The tax shield is the primary financial mechanism.