(i) a) Cost : The cost of raising funds can be classified under two types :
Cost of debt :
- A firm’* ability to borrow at a lower rate increases its capacity to employ higher debt.
- Thus, more debt can be used if debt can be raised at a lower rate.
Cost of equity :
- Shareholders expect a rate of return from equity, which is affected by using more debt capital.
- When a company increases debt, the financial risk faced by the equity holders, increases.
- Consequently, their desired rate of return may increase. It is for this reason that a company cannot use debt beyond a point. If debt is used beyond that point, cost of equity may go up sharply and share price may decrease inspite of increased EPS.
(b) Risk :
- The risk associated with different sources is different. Debt financing is risk prone source.
- The financial risk depends upon the proportion of debt in total capital.
- Debt is more risky because of interest payment obligation attached.
(C) Floatation cost: Cost of raising funds is called floatation cost. Higher the floatation cost, less attractive the source.
(d) Fixed operating cost :
- If a business has high level of fixed operating costs (e.g. building rent, Insurance premiums, salaries, etc. it must opt for lower fixed financing costs. Hence, lower debt financing is better.
- If fixed operating cost is less, more of debt financing may be preferred.
(e) State of Capital Market:
- Health of the capital market may also affect the choice of source of fund.
- During the ** when stock market is rising, more people are ready to invest in equity. However, depressed capital market may make issue of equity shares difficult for any company.
(ii) Capital Market:
(a) The term ‘capital market’ refers to facilities and institutional arrangements through which long-term funds, both debt and equity are raised and invested.
(b) Capital market satisfies long-term financial needs of the government and industrial sector.
(C) Capital market deals in medium in and long-term securities i.e. equity shares and debentures.
