why is interest expense said to cost the firm substantially less than the actual expense?

Question

why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100% of the outlay?

Answer 1

Wow, do you ever know how to phrase a question. Let's see if I can guess what you are saying. You have "interest expense" and "dividends" and you are concerned about costs.

Interest can be an expense or revenue, depending on whether you are paying for what you owe or receiving for what you loaned, respectively. Dividends are payments from profits for stockholders. Since we are talking about costs, the first issue is 'costing' borrowed money.

Why does a firm borrow money? To use it to help make more money. If you are buying raw materials to work with, then you add value to the materials when you work on it, but still there are waste and shortage issues (I bought boards 8 feet long, but they have to cut them to 7 feet, so I lose a board for every 8 we work with), so some of the value is lost in the process of using. This is different from borrowing money to buy a million coins to cull out the old and rare in the batch, then I only lose money if some cheaper foreign coin is unaccountably in the mix and I won't get full credit when selling them back to the bank or store chain I got them from or whatever. If I had to cash in the whole thing at the moment, such as if the bank has a "call" provision and they simply said they wanted their money back right now, I would come up short on the prinicple of the loan, perhaps to a greater degree than I would on the interest on the loan for the period elapsed.

A loan that paid for a hundred truckloads of tomatoes is expensed for the amount of the delivered tomatoes, but if the loan is suddenly "called" and you have them half squashed for making ketchup, you aren't anywhere near a sellable product for which you can repay the loan and perhaps profit from it, the original intent of the enterprise. The cost of delivered tomatoes and the cost of processing are just costs. The cost of tomatoes is just part of a larger operating expense, but one that is tied to the others. A certain high-dollar mashing and straining machine will just sit there if there are no tomatoes. The operator will likewise be an empty expense if there are no tomatoes. You borrow money to buy tomatoes, suddenly that cost gets bundled with the operating and amortization costs of the machine that processes them, it is a bundled value that could easily exceed the cost of interest during that operating day. By the way, I know a company in Arizona that had something like this happen to it, and the stockholders got no dividends--their company had to close because of some absurd financial decision to terminate a contract in the middle of operations. No one wanted the half-mashed tomatoes as a small ketchup maker was forced to close its doors and layoff a lot of good people when a manager in another company wanted to simplify his life by getting this contract off his to-do list before vacation. Business can be like that at times.

Answer 2

I believe that interest expense is a tax deductible expense while dividends are not.