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Every business be it small or large needs funds for various activities such as expansion, working capital or start-up. The quantum of funds required depends on the activity of the business for example the funds required in the case of working capital would be less than that required in the case of expansion of the business. A business help can procure funds from various sources such as equity, debt, retained earnings, venture capital and seed funds. However, the choice of source depends on the purpose of utilization of those funds. The main role of a finance manager of an organization is to maximize the wealth of its shareholders; this is a much broader concept than profit maximization and the choice of source of finance can sizeable contribute to this objective. As a consequence it is immensely important that the right mix of finances struck. There are a number of ways by which the sources of finance can be categorized however, primarily sources of finance can be categorized as own funds and loan funds. (Atkinson, 2005)
Own funds: These are the sources that primarily belong to the organisation in the broader perspective. The primary examples of such sources are equity and retained earnings. When a business opts for equity capital it has to issue shares our stocks to shareholders in exchange of the money. Though this money belongs to the shareholders the business is not required to pay it back till it has been liquidated by the order of the court. A business is considered to be a perpetual entity hence; it is assumed that the business will go on forever regardless of the change in its ownership. As a consequence it is considered that the business would not have to pay back the money of the shareholders. Retained earnings also form part of own funds. Read 10 earnings of those earnings which have been ploughed back by the organization over the years.
Loan Funds: as the name suggests loan funds are the funds that have been borrowed by the organization from the market. An organization has to pay interest on these types of funds. Examples of loan funds are debentures, term loans and bonds to name a few.
There are various sources of finance that can be availed by a small business or a big firm. With each source of finance given below, the implications for the business that can possibly crop up will be assessed. Sources which provide short term funds can only be used to cover working capital necessities. They cannot be used to finance fixed assets to meet the margin money for working capital loans. (Newlyn, 1968)
The credit given out by the supplier of goods or services to the customer in the regular course of business is known as trade credit. Due to competition, it forms a major portion of short term financing in a business. Trade credit is an unstructured source of finance which facilitates the regular course of business.
An accrued expense is an accounting expense which the company owes to a person or organization, but is already noted in the firm’s balance sheets. Accrued expenses are required to be paid sometime in the future. It is a liability that the company has to pay for the goods or services that it has already received.
When a firm has a fairly high credit rating, it can issue short term unsecured promissory notes called Commercial papers. First introduced in USA, it was a significant money market apparatus.
Inter-corporate deposit or ICDs are deposits made by one firm with another firm. The usual time period for such deposits is 6 months.
Long term finance permits a business to grow and expand by creating more assets and infrastructure. Some long term financial instruments are discussed below:-
It is the fundamental resource of finance for any business. An ownership interest of the business is sold to generate funds to finance the enterprise. Equity shareholders enjoy voting rights in all the affairs of the company. There is no maturity period for equity shares or any obligation to pay dividend on it. (Newlyn, 1968)
Preference share capital stands for the preference with regard to payment of dividend and the return of capital in case of liquidation of the business. It also confers ownership interest but with a maturity period. Preference shareholders have the right to collect dividends before equity shareholders.
The borrowing firm can issue debentures as a debt instrument. A debenture is an unsecured bond. The debenture holder is paid an interest, the rate and period of which is specified and promised by the borrowing firm at the time of issue.
A firm can obtain asset on lease from the lessor, instead of garnering funds to purchase the required equipment. Hire purchase is the condition when asset is purchased on credit and terms and condition are laid in the Hire Purchase agreement with regard to the payment. (Mason, 2007)
Loan given out by a bank with a repayment schedule and a floating interest rate is called a term loan. Its maturity period varies between 1 to 10 years.
Case 1: in this scenario the business needs to install building of £ 150,000 and equipment worth £ 400,000. In this case the business can finance the equipment through hire purchase and the building through debt-financed. The advantage of debt financing is that the interest paid on such loans is tax-deductible expenses which would allow the organization to save taxes. Purchasing machinery on hire purchase will allow the organization to save interest costs had the organization purchased the machinery out of its own retained earnings. (Faulkender and Petersen, 2006)
Case 2: in this case the individual can use the £ 70,000 received as redundancy payment and the rest can be financed through term loans. This would allow the individual to save interests on the £ 70,000 whereas the interest on the rest of £ 110,000 would be tax-deductible expense.
Case 3: considering the fact that the organization is a public limited company it can go for equity financing. This way the organization would not have to spend money as interest expenses.
Case 4: in this particular case the organization can ask the creditors to extend the credit period by three months. This would allow the organization to pay its bills on time. Trade credit is the most commonly used source of finance.
Case 5: as the club is in the process of being promoted to Zurich premiership the club can consider listing its shares as an option. This would allow the organization to have a solid capital base and above all it would not have to pay interest on the same.
Debt financing: the advantages of debt financing are that the interest paid on the same is tax-deductible. Hence, the real cost of debt is lower than the actual cost. However, too much of debt might have a negative impact on the liquidity position of the organization.
Equity financing: the biggest advantage of this source is that it does not have to be repaid during the lifetime of the organization however; issue of too many shares can dilute the capital base of the organization. (Rossi, 1928)
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