Question

Which of the following is associated with the lowest cost of capital for a firm?
A. Internally generated funds
B. Long-term debt
C. Preference shares
D. Convertible debt
D. Put options

Answer 1

Following is associated with the lowest cost of capital for a firm = Long- term Debt

Debt is a cheaper source of financing as compared to equity.

Internally generated funds have no cost since the company is not legally bound to pay any dividends or interest on its Internally generated funds, But this not true. the cost of Internally generated funds is equal to the cost of equity shares. the cost of internally generated funds must be considered as the amount of opportunity cost of the forgone dividends. Since equity shareholders forgo dividends, their expected rate of return on capital also increases ,i.e,cost of equity increases.

Cost of debt is less than cost of equity shares because interest on debt is a tax deductible expense while dividends are paid out of after tax profits.