Question

Discuss the types of sources a company can use to raise capital. Do these different sources of capital have different costs? Why or why not?

Answer 1

Company can broadly categorise its capital sources into three

1) Equity

2) Debt

3) Preferred Equity

Equity is the owner’s capital in the business and equity holders have stake in the residual value of the company. As they are the residual holders they get paid after all other claimants in the firm. As such it is the riskiest from an investors point of view. To compensate for the risk, the firm must pay a risk premium to the investors. This makes equity the costliest of the sources of capital

Debt Is provided by the external creditors  and is a statutory obligation on the part of the firm to repay the debt. Debt capital comes with cost called interest and this has to repaid periodically as agreed in the debt covenant. Debt generally has the lowest cost associated . However a high risk firm with high probability of default would have a high cost of debt.

Preferred equity lies between Debt and Equity and has a higher preference over common equity but comes after debt in the order of repayment. Preferred equity holders generally get repaid with a fixed rate which is costilier than debt but most likely to be cheaper than common equity.