While taking a financing decision, a firm must consider that the fund raising exercise also costs something. This cost is called __________.
Answer & explanation
Correct answer: option 4
The correct answer is Option (4) → floatation cost
Option (1) cost of capital — Incorrect. Cost of capital is the combined cost of all the funds a firm uses. The mix of debt and equity settles it, so it is a result of the financing decision as a whole.
Option (2) cost of debt — Incorrect. Cost of debt is the cost of borrowed funds, mainly the interest paid on debt. Debt is the cheapest source, and the tax deduction on interest makes it cheaper still.
Option (3) cost of equity — Incorrect. Cost of equity is the return shareholders expect for the risk they take. It belongs to equity funds alone.
Option (4) floatation cost — Correct. Raising funds has its own expenses, such as the cost of a public issue of shares or debentures. This cost of the fund raising exercise is the floatation cost. The higher it is, the less attractive the source.
NCERT (2026-27 Edition): “Financing Decision … 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. Financing decision is, thus, concerned with the decisions about how much to be raised from which source. This decision determines the overall cost of capital and the financial risk of the enterprise. …” |