Which of the following correctly explains why the cost of equity is typically higher than the cost of debt for a company?

The cost of equity is higher than the cost of debt for two fundamental reasons. First, risk: debt holders are senior creditors who receive fixed interest payments and have priority in liquidation  their risk is lower. Equity holders receive residual returns (only what is left after all obligations are met) and have no guaranteed return; in adverse scenarios, they may receive nothing. Higher risk demands higher expected return. Second, the tax shield: interest paid on debt is a tax-deductible expense, reducing the company’s taxable income. If the debt interest rate is 10% and the tax rate is 30%, the effective after-tax cost of debt is 10% × (1 − 0.30) = 7%. Dividends paid to equity shareholders are paid from post-tax profits  there is no such tax deduction. This tax shield makes the after-tax cost of debt significantly lower than its nominal rate, while the cost of equity is unaffected by tax.