Provided a company is expected to perform well, you can usually obtain debt financing at a lower effective cost. For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate, or you can sell a 25% stake in your business to your neighbor for $40,000.
Suppose your business earns a $20,000 profit during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
Conversely, had you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Therefore, your personal profit would only be $15,000, or (75% x $20,000).
