Ch 2 Sources of finance are classed as being either internal or external.Finance.ppt

Sources of finance are classed as being either internal or external.

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Chapter 2
Sources of Finance

2. Chapter Outline
Equity shares
Preference shares
Debenture/Bond
Term Loan
Internal accruals
Choosing the right Source of Finance
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3. Introduction
•Thischapterisintendedtoprovide:
Anintroductiontothedifferentsourcesoffinance
availabletomanagement,bothinternalandexternal.
Anoverviewoftheadvantagesanddisadvantagesof
thedifferentsourcesoffunds.
Anunderstandingofthefactorsgoverningthe
choicebetweendifferentsourcesoffunds.
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4. Cont…
•Whatisfinance?
Moneyusedtopurchasethingsthebusinessneedsorwants.
•Whatisasourceoffinance?
Itisamethodofgettingholdofthemoneyyouneed.Mostof
thetimeyouhavetopayitbackanditcanbeexpensive.
Whenmightabusinessneedfinance?
1.Whenitisstarting–up.
2.Whenitneedstobuyequipmentorpremises.
3.Whenitwantstoexpandthebusiness.
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5. Cont…
•Sourcesoffinanceareclassedasbeingeither
internalorexternal.
–Internalsources:
finance from within the business.
–Externalsources:
finance from outside the business.
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Sources Of
Finance
Security
Financing
Internal
Financing
Loan Financing
Equity
Shares
Preference
Shares
Debentures
Short-Term
Long-Term
Retained
Earnings
Depreciation
Fund

7. Ordinary (equity) shares
•Thesearealsoknownasequitysharesorcommon
shares.
•Ordinarysharesareissuedtotheownersofacompany.
Theyhaveanominalor'face‘value.
•Nomoneytopayback,nointeresttopay.
•Ownershipofthecompanyis“shared”betweenmore
people–dangerofapossibletakeover.
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8. •Deferredordinaryshares
•areaformofordinaryshares,whichareentitledtoa
dividendonlyafteracertaindateorifprofitsrise
aboveacertainamount.Votingrightsmightalso
differfromthoseattachedtootherordinaryshares.
•Ordinaryshareholdersputfundsintotheircompany:
a)bypayingforanewissueofshares.
b)throughretainedprofits.
Simplyretainingprofits,insteadofpayingthemoutintheformof
dividends,offersanimportant,simplelow-costsourceoffinance,
althoughthismethodmaynotprovideenoughfunds.
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Cont…

9. •Anewissueofsharesmightbemadeinavarietyof
differentcircumstances:
•a)Thecompanymightwanttoraisemorecash.
•b)Thecompanymightwanttoissuesharespartlyto
raisecash,butmoreimportantlyto‘float’itsshares
onastockexchange.
•c)Thecompanymightissuenewsharestothe
shareholdersofanothercompany,inordertotakeit
over.
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Cont…

10. Preference shares
•Preferenceshareshaveafixedpercentagedividend
beforeanydividendispaidtotheordinary
shareholders.
•Aswithordinarysharesapreferencedividendcan
onlybepaidifsufficientdistributableprofitsare
available,althoughwith'cumulative'preference
sharestherighttoanunpaiddividendiscarried
forwardtolateryears.
•Thearrearsofdividendoncumulativepreference
sharesmustbepaidbeforeanydividendispaidto
theordinaryshareholders.
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11. Fromthecompany'spointofview,preferenceshares
areadvantageousinthat:
•Dividendsdonothavetobepaidinayearinwhich
profitsarepoor,whilethisisnotthecasewith
interestpaymentsonlongtermdebt(loansor
debentures).
•Sincetheydonotcarryvotingrights,preference
sharesavoiddilutingthecontrolofexisting
shareholderswhileanissueofequityshareswould
not.
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Cont…

12. •Unlesstheyareredeemable,issuingpreference
shareswilllowerthecompany'sgearing.
Redeemablepreferencesharesarenormallytreated
asdebtwhengearingiscalculated.
•Theissueofpreferencesharesdoesnotrestrictthe
company'sborrowingpower,atleastinthesense
thatpreferencesharecapitalisnotsecuredagainst
assetsinthebusiness.
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Cont…

13. •However,dividendpaymentsonpreferenceshares
arenottaxdeductibleinthewaythatinterest
paymentsondebtare.
•Furthermore,forpreferencesharestobeattractive
toinvestors,thelevelofpaymentneedstobe
higherthanforinterestondebttocompensatefor
theadditionalrisks.
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Cont…

14. Fortheinvestor,preferencesharesareless
attractivethanloanstockbecause:
•theycannotbesecuredonthecompany'sassets.
•thedividendyieldtraditionallyofferedon
preferencedividendshasbeenmuchtoolowto
provideanattractiveinvestmentcomparedwiththe
interestyieldsonloanstockinviewoftheadditional
riskinvolved.
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Cont…

15. Debentures/Bonds
•Debenturesareaformofloanstock,legallydefined
asthewrittenacknowledgementofadebtincurred
byacompany,normallycontainingprovisionsabout
thepaymentofinterestandtheeventualrepayment
ofcapital.
Debentureswithafloatingrateofinterest
•Thesearedebenturesforwhichthecouponrateof
interestcanbechangedbytheissuer,inaccordance
withchangesinmarketratesofinterest.Theymay
beattractivetobothlendersandborrowerswhen
interestratesarevolatile.
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16. Cont…
•Security
•Loanstockanddebentureswilloftenbesecured.
Securitymaytaketheformofeitherafixedchargeor
afloatingcharge.
•a)Fixedcharge;Securitywouldberelatedtoa
specificassetorgroupofassets,typicallylandand
buildings.
•b)Floatingcharge;thelender'ssecurityintheevent
ofadefaultpaymentiswhateverassetsofthe
appropriateclassthecompanythenowns.
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17. Term Loans (Bank Lending)
•Borrowingsfrombanksareanimportantsourceof
financetocompanies.Banklendingisstillmainly
shortterm,althoughmedium-termlendingisquite
commonthesedays.
•Shorttermlendingmaybeintheformof:
•a)anoverdraft,whichacompanyshouldkeepwithin
alimitsetbythebank.Interestischarged(ata
variablerate)ontheamountbywhichthecompany
isoverdrawnfromdaytoday;
•b)ashort-termloan,forupto1year.
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18. Cont…
•Medium-termloansareloansforaperiodoffrom1
to5years.
•Therateofinterestchargedonmedium-termbank
lendingtolargecompanieswillbeasetmargin,
withthesizeofthemargindependingonthecredit
standingandriskinessoftheborrower.
•Aloanmayhaveafixedrateofinterestoravariable
interestrate,sothattherateofinterestchargedwill
beadjustedeverythree,six,nineortwelvemonths
inlinewithrecentmovementsintheBaseLending
Rate.
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19. •Lendingonoverdraftisalwaysatavariablerate.
•Aloanatavariablerateofinterestissometimes
referredtoasafloatingrateloan.
•Longer-termbankloanswillsometimesbe
available,usuallyforthepurchaseofproperty,
wheretheloantakestheformofamortgage.
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Cont…

20. •Whenabankerisaskedbyabusinesscustomerfora
loanoroverdraftfacility,hewillconsiderseveral
factors,knowncommonlybythemnemonicPARTS.
Purpose
Amount
Repayment
Term
Security
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Cont…

21. Internal accruals
•Internalaccrualsofafirmconsistofretained
earningsanddepreciationcharges.
Advantage:
–Arereadilyavailable
–Eliminateissuecostandlossonaccountofunder
pricing
–Nodilutionofownership/control
Disadvantages:
–Theamountavailablemaybelimited
–Opportunitycostishigh
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22. Choosing the right sources of finance
•Thecheapestoptionavailable–
•thecostoffinanceisnormallymeasuredintermsof
theextramoneythatneedstobepaidtosecurethe
initialamount–thetypicalcostistheinterestthat
hastobepaidontheborrowedamount.The
cheapestformofmoneytoabusinesscomesfromits
tradingprofits.
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23. Cont…
•Theamountofriskinvolvedinthereasonforthe
cash–
•aprojectwhichhaslesschanceofleadingtoaprofitis
deemedmoreriskythanonethatdoes.Potentialsourcesof
finance(externalsources)takethisintoaccountandmaynot
lendmoneytohigherriskbusinessprojects,unlessthereis
somesortofguaranteethattheirmoneywillbereturned.
•Thelengthoftimeoftherequirementforfinance–
•agoodentrepreneurwilljudgewhetherthefinanceneededis
foralong-termprojectorshorttermandthereforedecide
whattypeoffinancetheywishtouse.
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24. 4/5/2024 24
Chapter end questions
1.What is finance?
2.Explain three reasons why a business might need finance?
3.What is the difference between internal and external finance?
4.Explain at least two sources of finance that would not be relevant to your
business?
5.Explain the sources of finance that you will use in your business?
•Explain the advantages and disadvantages of each source of
finance.
•What will you use each source of finance for?

25. Exercise 2.1
•TechnoLivingCompany,anowner-managedcompanyinAddis
Ababacity,hasdevelopedanewtypeofheatingusingsolarpower,
andhasfinancedthedevelopmentstagesfromitsownresources.
Marketresearchindicatesthepossibilityofalargevolumeof
demandandasignificantamountofadditionalcapitalwillbe
neededtofinanceproduction.
AdviseTechnoLivingCompanyon:
a)theadvantagesanddisadvantagesofloanorequitycapital.
b)thevarioustypesofcapitallikelytobeavailableandthesourcesfrom
whichtheymightbeobtained.
c)themethod(s)offinancelikelytobemostsatisfactorytobothTechno
LivingLtd.andtheprovideroffunds.
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26. •End of chapter Notes!
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