Corporate Finance

Everyone knows borrowing costs money. What almost nobody grasps at first is that using your own cash costs money too. The moment a company spends a dollar of its own equity — whether by drawing on cash reserves or by issuing new shares — that dollar carries a cost, because the owners of that equity expect a return for the risk they're bearing. This is the foundation of the Weighted Average Cost of Capital: every source of financing has a price, and when you blend debt and equity together, you get a hurdle rate that every project must clear to create value rather than destroy it.

Here's why debt is the cheaper ingredient in that blend. Debt holders get paid first if a company goes under, so they take less risk than equity holders and charge a lower rate accordingly. Interest payments are also tax-deductible, which means the government effectively subsidizes a portion of your borrowing cost. Equity holders, sitting at the back of the line in bankruptcy, demand substantially more in return. So a company financing a project purely from its own cash is using expensive capital — equity — even if it never touches the credit markets.

Think of it this way: if your investors expect 11% per year and you fund a 9%-returning project with their capital, you have destroyed value — even if the project is profitable in absolute dollars. Mix in cheap, tax-advantaged debt and the blended hurdle drops; suddenly the same 9% project clears the bar and creates value.

Now here's where it gets harder in practice: how much debt is the right amount?