A company raising long-term funds in the capital market has to incur…

A company raising long-term funds in the capital market has to incur floatation costs. Which of the following is NOT a floatation cost?

Answer & explanation

Correct answer: option 2

The correct answer is Option (2) → Interest

Option (1) Brokerage — A floatation cost. Brokerage paid to brokers for selling the issue is a cost of floating the issue.

Option (2) Interest — Not a floatation cost. Floatation costs are the costs of floating an issue: brokerage, commission, printing of applications and advertising. Interest is the price paid for borrowing money, so it is not a cost of floating the issue.

Option (3) Printing of applications — A floatation cost. Application forms have to be printed for investors to apply. This is a cost of floating the issue.

Option (4) Advertising — A floatation cost. The issue must be advertised to reach the public. This too is a cost of floating the issue.

NCERT (Pre-rationalised Edition): “2. Commercial Paper: Commercial paper is a short-term unsecured promissory note, negotiable and transferable by endorsement and delivery with a fixed maturity period. It is issued by large and creditworthy companies to raise short-term funds at lower rates of interest than market rates. It usually has a maturity period of 15 days to one year. The issuance of commercial paper is an alternative to bank borrowing for large companies that are generally considered to be financially strong. It is sold at a discount and redeemed at par. The original purpose of commercial paper was to provide short-terms funds for seasonal and working capital needs. For example companies use this instrument for purposes such as bridge financing.”

“Example: Suppose a company needs long-term finance to buy some machinery. In order to raise the long term funds in the capital market the company will have to incur floatation costs (costs associated with floating of an issue are brokerage, commission, printing of applications and advertising etc.). Funds raised through commercial paper are used to meet the floatation costs. This is known as Bridge Financing.”