Debt Looks Cheaper Than Equity. Here Is the Arithmetic That Decides Whether It Is.

Every founder who has held a term sheet next to a sanction letter has had the same reaction. The bank wants 11 percent. The investor wants 20 percent of the company. On a business you believe will be worth ten times more in five years, that is not a close call. Debt wins the arithmetic, and it wins by a wide margin. The arithmetic is correct, but only under a condition almost nobody writes down at signing. The cost of being wrong about that condition never shows up in the interest line. It shows up two years later, in a negotiation you did not plan to have.

The comparison that actually matters

The honest comparison is not coupon versus dilution. It is post-tax cost of debt versus the return your capital employed actually generates, and separately, dilution priced at what the equity will be worth when it is sold.

Take a business with capital employed of INR 50 crore and EBIT of INR 9 crore. Pre-tax return on capital employed is 18 percent. Assume a term loan at a coupon of 11 percent and an effective tax rate of 25 percent. The post-tax cost of that debt is roughly 8.25 percent. The spread between what the capital earns and what the debt costs is close to 10 points, and every rupee raised at that spread lifts return on equity. That is the entire case for leverage, and it is a good one.

Now price the alternative. Raising INR 15 crore of equity at a pre-money valuation of INR 60 crore costs you 20 percent of the company. If the business is worth INR 250 crore at exit, that 20 percent has cost INR 50 crore. The same INR 15 crore as an amortising term loan over four years costs perhaps INR 4 to 5 crore of post-tax interest in total. Debt is not marginally cheaper here; it is cheaper by an order of magnitude.

What you are actually buying when you choose debt

That comparison holds on one condition: the business generates the cash flow it forecast, on roughly the schedule it forecast. Equity does not require that condition. It is the only instrument on your balance sheet that absorbs a bad year without triggering anything.

Run the same company through a plausible downside. EBITDA of INR 11 crore, a term loan of INR 15 crore amortising over four years, so principal of INR 3.75 crore plus interest of about INR 1.5 crore in year one. Annual debt service of roughly INR 5.25 crore against INR 11 crore of EBITDA is coverage above 2 times. Comfortable on paper, and exactly the number you will put in the credit memo. Now take EBITDA down 30 percent to INR 7.7 crore, an ordinary bad year rather than a catastrophe, and assume receivables and inventory absorb another INR 2 crore. Coverage collapses towards 1 time. You are not insolvent. You are worse placed than that: you are solvent, illiquid and out of negotiating room. The lender reprices, tightens, or asks for more security. And the equity you avoided raising at INR 60 crore pre-money now gets raised at INR 40 crore, because you are raising it into a stress event rather than a growth story. The dilution arrives anyway. It just costs more, and you no longer control the timing.

That is the real trade. You are not buying capital more cheaply. You are selling your tolerance for volatility, and the price you receive for it is the spread between the coupon and the cost of equity.

The four costs that sit outside the interest rate

The interest rate is the most visible part of a debt facility and usually the least important. Tenor mismatch is the most common and the most expensive of the costs around it. A four-year loan funding an asset that takes six years to pay back does not have an interest problem, it has a refinancing problem, and refinancing risk is priced by the market on the day you need it, not the day you signed. The same logic applies to funding losses on the way to scale with a repayable facility. Interest is a fixed obligation; the growth it funds is not.

Personal guarantees convert business risk into household risk. That is a change in the nature of the exposure, not a change in its size, and founders routinely underprice it because it costs nothing until it costs everything. Security creates similar lock-in: once your primary assets are charged, the next lender is junior, and junior money is materially more expensive.

Then there is optionality, which nobody puts a number on. A levered balance sheet limits your ability to acquire, invest through a downturn, or take a deliberate margin hit to win share, and lender consent rights give a third party a say in those decisions. At exit, net debt is subtracted from enterprise value rupee for rupee.

Where the rate cycle fits, and where it does not

Rates themselves are not the deciding variable, but they set the frame. The Reserve Bank of India held the repo rate at 5.25 percent at its August 2026 policy, with a neutral stance, having raised its FY27 growth forecast and trimmed its inflation projection. For a borrower, that means the benchmark under a repo-linked facility is unlikely to move sharply in the near term, and the real variability in your cost sits in the spread the lender charges, which is a function of your credit profile rather than of monetary policy.

So waiting for a better rate is usually a poor use of time. The largest lever on your borrowing cost is whether your financials, cash conversion and disclosure quality let a lender underwrite you as a lower-risk credit. A hundred basis points of spread is won in how you present the business, not in the month you approach the market.

Three questions to answer before you sign

Before you sign, answer three questions in writing. First, does the specific use of funds generate cash inside the tenor of the facility? If the money funds receivables, inventory or a capex with a payback shorter than the repayment schedule, debt is the correct instrument. If it funds market entry, product development or losses, it is not, whatever the coupon says.

Second, does the business service the debt at 65 to 70 percent of plan? Test coverage in the downside case, not the base case. If the facility only works when the plan works, you have not raised debt. You have written your lender an option on your equity.

Third, what does this facility do to your next round or your exit? Model the debt into the equity bridge. If the leverage improves return on equity in a base case but forces a distressed raise in a downside, you have not made the business cheaper to fund. You have made it more fragile, and fragility is repriced by the buyer.

Debt is cheaper than equity when the business has proven cash conversion, a real spread between return on capital and post-tax cost of debt, and an asset or receivable base that repays inside the tenor. It becomes the most expensive money you have raised the moment it substitutes for equity in a business still discovering its economics. The question worth asking is not which capital is cheaper. It is which risk you can afford to carry, and for how long.

Disclaimer

This article is for general information only and does not constitute financial, investment, tax, legal, or professional advice. The views expressed are for general informational purposes and should not be relied upon as a substitute for advice specific to your business or circumstances. Please seek appropriate professional advice before making any business, financial, investment, or transaction-related decision.