Why is equity typically considered more expensive than debt?

Equity is generally regarded as more expensive than debt primarily due to the higher expected rate of return associated with it, which compensates investors for the increased risk they undertake. Equity investors are essentially owners of the firm and, as such, they take on a residual claim on the firm's assets and earnings after all debt obligations have been satisfied. This essentially places equity investors in a riskier position compared to debt holders, who have a fixed claim and priority in the event of liquidation.

Investors in equity require a higher expected return because their investment isn't guaranteed and is subject to market risks, business risks, and the potential for volatility in returns. This higher required return reflects the potential for loss that equity investors face, as they will only receive profits after all debts are serviced and the company has generated sufficient income. Thus, the added risk leads to a higher cost of capital for equity compared to debt, making it more expensive for companies to finance their operations through equity.

Other options may discuss aspects of equity and debt financing but do not capture the primary financial rationale that ties risk to cost of capital as effectively as the correlation between higher expected returns and higher risk.