Long-term debt is usually the least expensive source of capital because interest is tax-deductible

What makes financing feel cheap? A quick look at the four common flavors of capital helps. In the real world, the least expensive source of funds isn’t always the one that’s most obvious at first glance. Here’s the gist you’ll want to carry with you: long-term debt often comes with the lowest after-tax cost, thanks to something many people overlook—the tax shield on interest.

Let me break down why that happens and how it stacks up against the other options.

Debt vs. equity: the basics you need to know

• Long-term debt: This is money you borrow for a while, with a set interest rate and a repayment schedule. Think bonds, bank loans, or other instruments with maturities longer than a year. The key advantage? The interest you pay is deductible from taxable income. In plain terms, the tax man helps you out a bit, which lowers the real cost of that debt. It’s like getting a discount on your borrowing.

• Common stock: If you raise money by selling ownership in the company, you’re inviting investors to share in profits—and losses. The “price” of common stock is not just the dividend, if there is one; it’s the higher return that investors expect for taking on more risk. In a liquidation, debt gets paid first. Equity investors are last in line, which is part of why their funding costs can be higher.

• Preferred stock: This sits between debt and common equity. It often comes with fixed dividends, which can be tempting for budgeting. But those dividends aren’t tax-deductible for the company, and the security still faces market price risk. So while it can be cheaper than common stock in some cases, it rarely carries the same tax advantage as debt.

• Retained earnings: This is money the company has earned and kept instead of paying it out as dividends. It’s internally generated capital, so there’s no external interest or dividend cost. The downside? It isn’t infinite, and it isn’t always available for every project. Retained earnings reflect opportunity costs—the value you could have created by using those funds somewhere else.

Why is debt often the cheapest?

• The tax shield is the big ticket item. When you pay interest, you reduce taxable income. That reduction lowers the net cost of borrowing after taxes. It’s a mechanical benefit, and for many firms, it’s sizable.

• Risk and return are priced. Lenders take on less risk than equity investors because debt holders have a higher position in the capital structure. In exchange for that lower risk, they demand interest. Still, compared to the cash outlay required to issue new stock, debt costs (especially after tax) tend to come out ahead.

• Timing matters. If interest rates are favorable and a company has solid credit, long-term debt can lock in low costs for a long stretch. Rate locks, covenants, and amortization schedules all influence the final price tag. And yes, those dynamics change with the macro environment, which is why risk managers keep a weather eye on the debt market.

The tax shield: a closer look

Curious about how this tax effect actually shows up on the bottom line? Here’s the lean version:

• Interest expense reduces taxable income.

• Lower taxable income means lower taxes.

• The after-tax cost of debt becomes: interest rate times (1 minus the tax rate).

Put simply, part of the cost gets subsidized by the tax authority, which makes debt cheaper in after-tax terms than it might appear at first glance.

Keep in mind, though, that tax considerations aren’t the whole story. If debt loads grow too large, the company can become fragile in a downturn. The same shield that lowers costs in good times can pin you down with higher leverage risk when revenues slip. For risk managers, that balance—cost efficiency vs. resilience—is where the real work happens.

Why not other sources? A quick comparison

• Common stock: The returns investors expect are not just about growth; they reflect the higher risk of being last in line if things go south. That risk premium pushes up the cost of equity. And distributing profits via dividends isn’t a tax shield for the company. In a rising tax environment or a weaker revenue period, the cost can look steeper than debt.

• Preferred stock: The fixed dividends are predictable, which helps some budgeting needs. Yet they don’t shield taxes the way debt does. If rates drift higher, new issues of preferred stock may become costly relative to existing obligations, and the terms can become less favorable.

• Retained earnings: Internally generated funds feel “cheap” because there’s no external price tag or debt service. But you’re sacrificing potential dividends to shareholders and the cash could be used elsewhere—research, expansion, or a cash reserve. It’s not a free lunch; it’s a trade-off with opportunity cost baked in.

A practical way to think about financing choices

Consider a simple scenario you might run into in the field: you’re weighing a growth project that needs capital over the next five to seven years. You could fund it with long-term debt, issue new common stock, or use retained earnings. Here’s how to reason it through:

• Step 1: Estimate the after-tax cost of each option.

• Debt: take the interest rate, apply (1 minus the tax rate).

• Equity: think about the return required by investors, including dividend expectations and capital gains potential.

• Retained earnings: factor in the opportunity cost of not distributing those profits or investing them elsewhere.

• Step 2: Weigh the risk implications.

• Debt adds fixed obligations. A downturn can strain cash flow, even if the tax shield was appealing earlier.

• Equity dilutes ownership and profits, but it doesn’t require cash outlay in the same way debt does during hard times.

• Retained earnings are flexible but limited by profitability and the company’s current liquidity.

• Step 3: Align with strategy and risk tolerance.

• If you’re aiming for aggressive growth and comfortable with higher leverage, debt can be a good accelerator.

• If you value financial resilience and a lighter balance-sheet footprint, you might lean more on internal funds or equity with prudent terms.

A few real-world caveats

• Not all debt is created equal. Secured vs. unsecured, fixed vs. floating rates, covenants, and maturity profiles all shape cost and risk. A cheaply priced loan today can look expensive if covenants bite or rates swing unfavorably tomorrow.

• Tax regimes vary. The deduction benefit depends on tax law and the jurisdiction. In some places, the advantage isn’t as pronounced, so the math shifts.

• Market appetite changes. When credit markets tighten, even debt that used to be cheap can become more costly or harder to obtain. Risk managers keep an eye on liquidity metrics and debt capacity.

Digressions that still stay on track

While we’re at it, a quick tangent about how teams talk about capital can reveal a lot about risk posture. Some leaders treat debt like fuel for growth—great in moderation, dangerous in excess. Others emphasize a conservative stance, preferring to fund with internal cash or equity to preserve flexibility. Both camps want to avoid a scenario where debt service becomes a choke point during a downturn. It’s not just a numbers game; it’s about balance, timing, and the nerve to act when opportunity knocks without inviting trouble the moment skies turn gray.

Putting it into a compact takeaway

• Long-term debt is often the least expensive form of external capital because of the tax shield on interest. This reduces the after-tax cost of borrowing.

• Common stock and preferred stock carry higher costs in most cases because they don’t enjoy the same tax advantages, and equity investors expect a return that reflects higher risk.

• Retained earnings can be a cheap source of funds, but they’re limited by profits and available cash, and they carry opportunity costs.

What this means for practical decision-making

When you’re calculating project viability or shaping a corporate financing plan, factor in after-tax costs and the risk implications of each option. The cheapest funding on a spreadsheet isn’t always the best choice in the long run if it undermines resilience or constrains strategic options in lean times. That’s the core wisdom: cost is important, but clarity about risk, flexibility, and future needs matters just as much.

A simple cheat sheet to keep in mind

• After-tax cost of debt = interest rate × (1 − tax rate)

• Equity cost reflects investor expectations and risk premium

• Retained earnings = internal funding, no external price tag but limited by profits

• Debt improves tax bill but adds fixed obligations

• Equity avoids fixed payments but dilutes ownership and carries higher return expectations

If you enjoy thinking through money flows with a bit of nuance, this topic keeps showing up in risk management discussions. It’s one of those fundamental ideas that quietly shapes the way plans get drawn, projects get approved, and budgets get built. And when you get comfortable with it, you’ll notice it across strategy, liquidity management, and even stress-testing scenarios.

In short, long-term debt tends to be the least expensive source of capital because of the tax shield on interest. That doesn’t mean it’s the right choice every time, but it does explain why debt often shows up as the preferred starter option in many financing conversations. As you continue exploring risk management concepts, you’ll find this theme—costs, protections, and timing—pops up again and again, tying together the big picture with the practical day-to-day decisions that keep a business solvent and growing.