Read the following passage and answer the question.

RST Ltd. is registered with capital of ₹20 crore. The paid up capital is ₹12 crore. The company was facing shortage of funds so management decided to raise funds by issue of equity shares of ₹100 each. The issue was fully subscribed by public. After some time, it was realised that the funds raised were in excess of the actual requirement.  The company raised the funds for expanding the business of manufacturing steel.

Which of the following is a cheaper source of finance?

Debentures

The correct answer is option 3- Debentures.

The cost of each type of finance has to be estimated. Some sources may be cheaper than others. For example, debt is considered to be the cheapest of all the sources, tax deductibility of interest makes it still cheaper. Associated risk is also different for each source, e.g., it is necessary to pay interest on debt and redeem the principal amount on maturity. There is no such compulsion to pay any dividend on equity shares. Thus, there is some amount of financial risk in debt financing. The overall financial risk depends upon the proportion of debt in the total capital. The fund raising exercise also costs something. This cost is called floatation cost. It also must be considered while evaluating different sources.