Debt vs. Equity Financing: What an Interviewer Wants to Hear You Weigh

There's no right answer to “should this company raise debt or equity,” and the interviewer knows that. What they're grading is whether you can name the tradeoffs and pick a side for a reason.

Some version of this question shows up in almost every technical round. “A company needs $500 million. Should it raise debt or equity?” Or the shorter one: “Why is debt cheaper than equity?” Or the follow-up that catches people: “Then why doesn't every company fund itself entirely with debt?”

A weak answer picks one and defends it. A good answer says “it depends,” and then immediately says what it depends on, in a sensible order, and lands on a choice for the specific company in front of you. That last step matters. Plenty of candidates list every factor they know and never commit.

Why debt is cheaper

Start here, because almost every other part of the answer builds on it. Debt is cheaper than equity for two separate reasons, and you should name both.

1. Lenders take less risk. They get a fixed interest payment and they get paid before shareholders if the company is liquidated. Shareholders get whatever is left over, which might be a lot or might be nothing. Less risk means a lower required return.
2. Interest is tax-deductible. A company paying 8% interest at a 25% tax rate has an after-tax cost of debt of 6% (8% times one minus 25%). Dividends paid to shareholders get no such deduction.

The cost of equity, meanwhile, usually comes out of CAPM, which adds beta times the equity risk premium to the risk-free rate. For most companies that number lands well above the after-tax cost of debt. It doesn't show up as a line on the income statement, which is why candidates sometimes talk about equity as if it were free. It isn't. Shareholders expect a return, and if they don't get it, the share price pays for it.

So why not fund everything with debt?

Because each extra dollar of debt makes the rest of the capital structure more expensive. This is the part interviewers actually want to hear.

• The cost of equity goes up. More debt means more fixed payments ahead of shareholders, so their returns swing harder in good years and bad ones. That shows up as a higher levered beta and a higher cost of equity.
• The cost of debt goes up too. Past a certain leverage level, lenders charge more, ask for tighter covenants, or stop lending altogether. A rating downgrade can move the rate on every new dollar borrowed.
• Financial distress costs start to bite. A company close to breaching its covenants loses flexibility. It may cut investment, lose customers or suppliers who worry about its staying power, and spend real money on advisors.
• The tax shield only helps if there's taxable income to shield. A company with thin or negative earnings gets little value from the deduction.

Put together, WACC tends to fall as a company adds debt from zero, flatten out, and then rise once the risk effects outweigh the cheaper cost and the tax benefit. The target capital structure sits somewhere around the bottom of that curve. Nobody can point to the exact bottom, and you don't need to in an interview. You need to know the shape and why it has that shape.

What the decision actually depends on

When the interviewer gives you a specific company, walk through the factors that actually move the decision. You don't need all of these every time. Pick the ones that fit the facts you were given.

How stable are the cash flows?

Debt needs to be serviced every quarter whether the business had a good quarter or not. A utility or a mature consumer staples company with predictable cash flow can carry a lot of it. An early-stage software company burning cash can't carry much at all, which is why startups raise from venture investors rather than banks.

How much debt is already there?

Look at leverage (total debt over EBITDA) and coverage (EBITDA over interest expense). If the company is already levered close to where its peers sit, or close to its covenant limits, more debt gets expensive fast and equity starts to look better.

Where is the stock trading?

If the share price is high relative to earnings, the company can raise a lot of money while giving up relatively little ownership. If the stock has been beaten down, issuing shares means selling a bigger slice of the company for the same dollars, and existing shareholders take the hit.

What signal does it send?

Markets often read an equity raise as management thinking the stock is fully valued, since that's when issuing shares is most attractive to them. Share prices commonly dip on the announcement. Debt sends a different message, closer to “we're confident we can make these payments.” You don't need to overstate this, but mentioning it shows you think about how the market reacts and not only about the math.

What is the money for?

Matching matters. Funding a long-lived asset that throws off steady cash, like a manufacturing plant or an acquisition of a mature business, fits well with long-term debt. Funding something speculative, like a new product line that may or may not work, fits better with equity, because equity doesn't demand a payment if the bet fails.

Who wants to keep control?

Debt doesn't dilute anyone's ownership or voting power. For a founder-led company, or a family that controls the shares, that can outweigh a lot of the cost argument.

The EPS math, with numbers

Interviewers sometimes turn the question into arithmetic. Here's a clean example to practice on.

A company has 20 million shares outstanding and net income of $40 million, so EPS is $2.00. It needs $100 million for a project that will add $15 million of EBIT. Tax rate is 25%.

Option A: borrow at 8%

• Interest expense is $8 million, so the project adds $7 million of pre-tax income ($15 million of EBIT less $8 million of interest).
• After tax that's $5.25 million, so net income goes to $45.25 million.
• Share count doesn't change. EPS is $45.25 million over 20 million shares, about $2.26.

Option B: issue shares at $50

• $100 million at $50 a share means 2 million new shares, so 22 million total.
• No interest, so the project adds $15 million times 75%, or $11.25 million. Net income goes to $51.25 million.
• EPS is $51.25 million over 22 million shares, about $2.33.

Equity wins on EPS here, which surprises people who just memorized “debt is cheaper.” The reason is the share price. At $50 and $2.00 of EPS, the stock trades at 25 times earnings, so its earnings yield (EPS over price) is 4%. That's below the 6% after-tax cost of debt, so each dollar raised through shares costs less EPS than each dollar borrowed.

Now run it with the stock at $20 instead. The company needs 5 million new shares, net income is still $51.25 million, and EPS drops to $51.25 million over 25 million shares, or $2.05. The debt option still gives about $2.26, since the share price doesn't affect it at all. At 10 times earnings, the earnings yield is 10%, above the 6% cost of debt, so debt wins.

That comparison (after-tax cost of debt against the earnings yield) is the same shortcut used in accretion/dilution analysis. One caveat worth saying out loud if you get the chance: the earnings yield isn't the true cost of equity. Shareholders still expect their CAPM return. EPS is a useful check on how a deal looks in the next year, not a full answer to which financing creates more value.

How each one hits the statements

Expect this as a follow-up. Raising $100 million of debt: cash goes up by $100 million on the balance sheet, debt goes up by $100 million on the other side, and cash flow from financing shows the $100 million inflow. Nothing hits the income statement on day one. Later, interest expense lowers pre-tax income, and net income falls by the after-tax amount.

Raising $100 million of equity: cash goes up by $100 million, shareholders' equity goes up by $100 million (common stock and additional paid-in capital), and financing cash flow shows the inflow. No income statement impact at all, ever, from the raise itself. The cost shows up in the share count instead.

A sample answer, out loud

Say the interviewer describes a mature industrial company with steady cash flow, leverage around 1.5 times EBITDA, and a stock that's fallen 30% this year, looking to fund an acquisition. Something like this works:

“I'd lean toward debt. The cash flows are steady enough to service it, and at 1.5 times leverage there's room before it gets expensive or tight on covenants. Interest is tax-deductible, so the after-tax cost is lower than the equity alternative. And with the stock down 30%, issuing shares now means selling more of the company than we'd want to for the same dollars. I'd check that the combined company's leverage stays in line with peers after the deal, and if it got too high, I'd consider funding part of it with stock.”

That's maybe 30 seconds. It picks a side, gives three reasons tied to the facts, and names the condition that would change the answer.

Where answers go wrong

• Saying equity is free because there's no interest payment. Shareholders expect a return, and it's usually the most expensive capital the company has.
• Forgetting the tax shield when explaining why debt is cheaper. Risk is half the answer, taxes are the other half.
• Saying more debt always lowers WACC. It does up to a point, and then the rising cost of equity and debt reverses it.
• Listing every factor and never choosing. The interviewer asked what you'd do.
• Ignoring the facts you were given. If they told you the company is a cash-burning startup, a long answer about the tax shield misses what they set up.

Common questions

If the financing question comes up inside a deal scenario, it usually leads straight into returns. See common LBO interview mistakes for the version of this where the debt is the whole point.