Question

Which one of the following statements is NOT true? Select one: A. The need for funding does not end when a company goes public. B. Approval is obtained from the board of directors to issue securities. C. The lowest-cost source of external funds is often an open offer to the public. D. The investment bank decides how much money the company needs to raise and what type of security - such as debt, ordinary shares or preference shares - to issue.

Answer 1

Ans) option C: The lowest cost source of external funds is often an open offer to the public.

The above stated proposition is not true.

Two ways of external funding is Equity financing (includes making an open offer to public) and Debt financing.

Debt financing requires the borrower to pay interest on the amount of debt taken while Equity financing involves selling a part of company's ownership. Financing through debt is usually cheaper than financing through equity.

Lets understand this with an example,

Suppose, your company needs financing of abhout $50,000.

You can either take a bank loan of $50,000 at 10% interest or sell 25% stake of the company for $ 50,000.

Suppose, next year your company incur a profit of $30,000. If you had taken the loan you would pay 10% * 50,000 for that year, i.e. $ 5000. Your total profit would then become $30,000 - $ 5000 = $ 25,000.

Whereas, if you had sold 25% stake, that would mean you would get 75% of the profit for the total profit each year, which is equal to 75% * $ 30,000 = $ 22,500. This profit is lesser than the profit in case of debt financing.

Another point to be noted is that in case of debt financing the taxes paid will be lesser because interest expenses are tax deductable which means before calculating taxes form net profit, interest expenses are deducted from the net profit, reducing its value and hence reducing the taxes paid on that reduced net profit.

Therefore, debt financing is usually the cheapest form of external debt and not equity financing.