Technical / Capital
Debt
What debt is, how it works in corporate finance, and why lenders have priority over shareholders in the capital structure.
"Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery." — Charles Dickens, David Copperfield
Concept
Debt is borrowed capital that must be repaid with interest. Unlike equity, debt holders have a contractual claim to specific payments regardless of company performance. If a company misses a debt payment, creditors can force bankruptcy and seize assets. This priority makes debt cheaper than equity—but that cheapness comes with covenants, schedules, and the ever-present risk of default.
Intuition
Debt exists because lenders accept lower returns in exchange for contractual certainty. Equity holders take unlimited upside but can lose everything. Debt holders cap their upside at the interest rate but get paid first.
From a company's perspective, debt is cheaper than equity for two reasons:
- Priority: Less risky for investors, so they demand lower returns
- Tax Shield: Interest is deductible; dividends are not
The catch: debt is unforgiving. Miss a payment, breach a covenant, or face a downturn at the wrong time, and creditors take control. Equity investors can wait out bad years. Debt holders don't have to.
Components
Principal and Interest
What It Is
Principal is the original amount borrowed. Interest is the cost of borrowing, expressed as a rate applied to principal.
How to Calculate It
A $100M loan at 8% annual interest costs $8M per year.
Interview Script
Debt is borrowed capital that must be repaid with interest, where lenders have a contractual claim to specific payments regardless of company performance. It's cheaper than equity for two reasons: debt holders accept lower returns because they get paid first in the capital structure, and interest payments are tax-deductible unlike dividends. The tradeoff is that debt is unforgiving—miss a payment or breach a covenant, and creditors can force bankruptcy and seize assets.