Final answer:
Debt financing is less costly because of tax deductions, but it is also risky due to the obligation to repay the debt regardless of financial condition.
Step-by-step explanation:
Debt financing is less costly because the interest payments on debt are tax-deductible, meaning that businesses can deduct the interest expense from their taxable income. This lowers the effective cost of debt. However, debt financing is also high-risk because the company has an obligation to repay the principal and interest on the debt, regardless of its financial condition. If the company is unable to meet its debt obligations, it may face bankruptcy or other financial difficulties.
For example, if a company takes on too much debt and its profitability decreases, it may struggle to make its debt payments. In contrast, equity financing does not require regular interest payments or repayment of principal. Instead, equity investors become owners of the company and share in its profits and losses. While equity financing may be more expensive due to the need to share profits, it does not pose the same risk of bankruptcy or default as debt financing.