Read the Paragraph given below carefully and answer the following question.

Sunrises Ltd. dealing in readymade garments, is planning to expand its business operations in order to cater to international market. For this purpose the company needs additional ₹80,00,000 for replacing machines with modern machinery of higher production capacity. It involves committing the finance on a long term basis. These decisions are very crucial for any business since they affect its earning capacity in the long run. The company wishes to raise the required funds by issuing debentures. The debt can be issued at an estimated cost of 10%. The EBIT for the previous year of the company was ₹8,00,000 and total capital investment was ₹1,00,00,000. Instead of issuing 10% Debenture the Company can issue Equity Shares for raising the fund. The financial manager of the company would normally opt for a source which is the cheapest.

The financing decisions are affected by various factors.

Which one of the following factor is discussed in the above case?

Cost of raising funds

The correct answer is option 2-Cost of raising funds.

The paragraph mentions the cost of issuing debentures (10%) and implies that the financial manager would opt for the cheaper source of finance. This directly relates to the cost of financing.

Financing Decision is about the quantum of finance to be raised from various long-term sources. The financing decisions are affected by various factors. Important among them are as follows:

(a) Cost: The cost of raising funds through different sources are different. A prudent financial manager would normally opt for a source which is the cheapest.

(b) Risk: The risk associated with each of the sources is different.

(c) Floatation Costs: Higher the floatation cost, less attractive the source.

(d) Cash Flow Position of the Company: A stronger cash flow position may make debt financing more viable than funding through equity.

(e) Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent, Insurance premium, Salaries, etc.), It must reduce fixed financing costs. Hence, lower debt financing is better. Similarly, if fixed operating cost is less, more of debt financing may be preferred.

(f) Control Considerations: Issues of more equity may lead to dilution of management’s control over the business. Debt financing has no such implication. Companies afraid of a takeover bid would prefer debt to equity.

(g) State of Capital Market: Health of the capital market may also affect the choice of source of fund. During the period when stock market is rising, more people invest in equity. However, depressed capital market may make issue of equity shares difficult for any company.