Question

4. The firm's overall cost of capital that is a blend of the costs of the different sources of capital. Describe the three possible sources of capital for a firm.

Answer 1

Three possible sources of capital for a firm are

1. Equity - A firm raises capital through issue of shares. Shares are issued to the public who pay the consideration in the form of cash.This is one of the major source of capital for a firm. In many instances the owners themselves provide the finances from their own to run the firm. Equity capital is genreally used for the long term objectives of the firm.
2. Debt - This capital is generally in the form of loans taken from financial institutions or through the issue of debentures. Here the firm has to repay the loans taken and to the debenture holders. Here the cost of capital is Interest. Banks while granting loans and advances charge certain interest on the borrowing which the borrower has to pay along with the principal amount. Most firms would look form debt financing for fulfilling both short term and long term objectives. However default in repayment of loans may also lead to serious financial implications for the firm.
3. Retained Profits - When the business earns profit it may want to reinvest such profits into the business. This type of reinvestment ensures that there is no dilution of ownership. As profits are generated from the business itself, it simply adds in the gowth of the business of the firm.There is no risk involved with this type of capital.