Question

During periods of normal credit market conditions, which financing strategy will result in the highest borrowing costs?

Answer 1

A. INTRODUCTION:

1. Sources of finance and capital structure are the most important dimensions of a strategic plan.

2. The generation of funds may arise out of ownership capital and or borrowed capital. A company may issue equity shares and/or preference shares for mobilizing ownership capital and debentures to raise borrowed capital.

Examples of Financial strategies:

• Debt Financing
• Equity Financing

3. Financing cost is the cost, interest, and other charges involved in the borrowing of money.

4. So the broad sources of borrowing cost are the cost of debt (Interest) and cost of equity (Dividends) which is generally expressed as K_d & K_e respectively.

B. FINANCIAL STRATEGY THAT LEADS TO HIGHEST BORROWING COST:

1. The thumb rule to measure the intensity of any cost is to measure its risk. For instance, if the risk borne by the company is less, usually the cost to the company will be lower.

2. In case of money raised through debt funds, debt providers were given security to the amount lent by them. Also since the coupon amounts to be paid to the lenders is fixed at the beginning of raising funds, this makes the cashflow certain to the company and hence making it less risky.

3. However, in the case of Equity funds, the shareholders are the risk-takers as they are agreed to take part in the uncertainty of the business of the company whether it is profit or loss. Hence, they were paid the part of the surplus left over after meeting all other allocations.

C. CONCLUSION:

It is clear from the above that equity funds generally have the highest borrowing cost as they are most risky.