Chapter-15 Sources of finance

Criteria for choosing between sources of finance

A firm must consider the following factor:
1. Cost:
The higher the cost of funding, the lower the firm’s profit. Debt finance tends to
be cheaper than equity. This is because providers of debt take less risk than
providers of equity and therefore earn less return. Interest on debt finance is
also normally corporation tax deductible while dividends paid to equity holders
are not.
2. Duration:
Finance can be arranged for various time periods. Normally, long-term finance is
more expensive than short-term finance. This is because lenders normally
perceive the risks as being higher on long-term advances. Long-term finance
carries the advantage of security whereas sources of short-term finance can
often be withdrawn at short notice.
3. Term structure of interest rates:
It describes the relationship between interest rates charged for loans of differing
maturities. While short-term funds are usually cheaper than long-term funds,
the situation is sometimes reversed and interest rates should be carefully
checked.
4. Gearing:
Gearing is the ratio of debt to equity finance. Although high gearing involves the
use of cheap debt finance, it does bring with the risk of having to meet regular
repayments of interest and principal on the loans. Debt could result in earnings
dilution.
5. Accessibility:
Not all companies have access to all sources of finance. Small companies
traditionally have problems in raising equity and long-term debt finance. A
quoted company is one whose shares are traded on a recognised stock market,
so shares in such a company represent a highly liquid asset. Investment in shares
of unquoted companies represents the acquisition of a highly illiquid investment

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Relationship between risk and returns
Investment risk arises because returns are variable and uncertain. An increase in
risk generally requires an increase in expected returns.
Short-term sources of finance
Short-term sources of finance are used to meet the immediate financial needs
of a business. These sources typically involve borrowing funds or obtaining credit
that is repaid within a relatively short period, usually within one year. Here are
some common short-term sources of finance:
➢ Bank Overdraft: This is a facility provided by banks that allows
businesses to withdraw more money than they have in their account,
up to a certain agreed limit. Interest is charged on the overdrawn
amount.
➢ Short-term Loans: Businesses can obtain short-term loans from banks
or other financial institutions to cover temporary cash flow shortages.
These loans are typically repaid within one year and may have a higher
interest rate compared to long-term loans.
➢ Trade Credit: Suppliers may offer trade credit, allowing businesses to
purchase goods or services on credit terms, such as "net 30 days,"
where payment is due within 30 days of receiving the invoice.
➢ Factoring: This involves selling accounts receivable (unpaid invoices) to
a third party (factor) at a discount. The business receives immediate
cash, while the factor assumes the responsibility of collecting payment
from customers.
➢ Commercial Paper: Large, creditworthy corporations can issue short-
term unsecured promissory notes called commercial paper to raise
funds from investors. These notes typically mature in less than a year.
➢ Lines of Credit: Similar to overdrafts, lines of credit provide businesses
with access to funds up to a predetermined limit. Interest is charged
only on the amount borrowed, and repayment terms are flexible.
➢ Accruals: Accrued expenses, such as wages, taxes, and utilities,
represent liabilities that accumulate over time but are not yet paid. By
delaying payment of these expenses, businesses can free up cash for
other short-term needs.
➢ Inventory Financing: Businesses can use inventory as collateral to
secure short-term loans. This type of financing allows them to leverage
their inventory to obtain funds for immediate needs.
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Each of these sources has its advantages and considerations, and businesses
often use a combination of these options to manage their short-term financing
requirements effectively.
Types of share capital
Equity share- It is the investment in a company by the ordinary shareholders,
represented by the issued ordinary share capital plus reserves.
Preference shares- It comes with a preferential right when it comes to the
distribution of dividends or during the liquidation of company.
a. Cumulative preference shares-
➢ It gives the holder the right to dividends that may have been missed, or
reduced in the past.
➢ Limited right to vote at a general meeting. Rank after all creditors but
usually before ordinary shareholders in liquidation.
➢ A fixed amount per year at the discretion of the directors. Arrears
accumulate and must be paid before a dividend on ordinary share may be
paid.
➢ A fixed amount per share
b. Non-Cumulative preference share-
➢ The shares that do not pay shareholders any unpaid or omitted dividends.
➢ Typically acquire some voting rights if the dividend has not been paid for
three years. Rank as cumulative in liquidation.
➢ A fixed amount per year as above. Arrears do not accumulate.
➢ A fixed amount per share
Raising equity
There are three main sources of equity finance-
1. Internally-generated funds – retained earnings
2. Rights issues
3. New external shares issues – placings, offers for sale, etc.
1. Internally generated funds
➢ Internally generated funds are earnings retained in the business i.e.
undistributed profits attributable to ordinary shareholders.

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 ➢ They are generated as a result of increased working capital management
efficiency and from successful short and long-term projects.
➢ Such finance is cheap and quick to raise, requiring no transaction costs,
professional assistance or time delay.
➢ Retained earnings are also a continual source of new funds, provided that
the company is profitable and profits are not all paid out as dividends.
2. Rights Issues
A rights issue is an offer to existing shareholders to subscribe for new shares at
a discount to the current market value in proportion to their existing holdings.
This right of pre-emption:
➢ Enables them to retain their existing share of voting rights
➢ Can be waived with the agreement of shareholders
Shareholders not wishing to take up their rights can sell them on the stock
market.
Advantages:
➢ It is cheaper than a public share issue
➢ It is made at the discretion of the directors without consent of the
shareholders or the stock exchange
➢ It rarely fails
TERP
The new share price after the issue is known as the theoretical ex-rights price. It
is calculated by finding the weighted average of the old price and the rights price,
weighted by the number of shares. The formula is:
Ex-rights price = (Market value of shares already in issue + proceeds from new
share issue)/Number of shares in issue after the rights issue (ex-rights)
The value of a right
To make the offer relatively attractive to the shareholders, new shares are
generally issued at a discount on the current market price. The formula is:
➢ Value of a right = theoretical ex rights price – issue (subscription) price
➢ Value of a right per existing share = (TERP – issue [subscription] price)/No
of shares needed obtain a right

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Since rights have a value, they can be sold on the stock market in the period
between:
➢ The rights issue being announced and the rights to existing shareholders
being issued
➢ The new issue actually taking place
Shareholder’s options
The shareholder’s options with a rights issue are to:
➢ Take up their rights by buying the specified proportion at the price offered
➢ Renounce their rights and sell them in the market
➢ Renounce part of their rights and take up the remainder
➢ Do nothing
3. New external share issue
a. Placing- A placing may be used for smaller issues of shares. The bank advising
the company selects institutional investors to whom the shares are placed or
sold. If general public wish to acquire shares, they must buy them from the
institutions.
Unquoted companies may find it difficult to raise finance because:
➢ Shares are not easily realisable
➢ It is cheaper to invest in large parcels of shares rather than in many
companies
➢ Small firms are regarded as more risky
b. Public offer- A public offer is an invitation to the public to apply for shares in
a company based upon information contained in a prospectus, either at a fixed
price or by tender.
➢ Fixed price offer- Shares are offered at a fixed price to the general public.
Details of the offer document are published in a prospectus for the issue.
The prospectus contains information about the company’s past
performance and future prospects as specified by the rules for stock
exchange companies.
➢ Offer for sale by tender- It is public invitation to all shareholders to tender
their stock for sale at a certain price during a specific period of time.
Shares are offered to the general public but no fixed price is specified.

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 Potential investors bid for shares at a price of their choosing. The strike
price at which the shares are sold is determined by the demand for shares.
c. Introduction- It is process that allows a company to join a stock exchange
without raising capital. A company does not issue any fresh shares, it merely
introduces its existing shares in the market. It is used where the public holds at
least 25% of the shares in the company. The shares become listed and members
of the public can buy shares from the existing shareholders.
d. Issuing house- It is an investment bank specialising in new issues of shares.
e. Investment banks- A company wishing to raise capital by offer for sale would
first get in touch with a bank that specialises in this kind of business. The bank
earns a fee by organising public issues. It purchases outright a block of shares
from a company and makes them an offer for sale to the public on terms
designed to bring in a profit to the bank. Investment banks also perform the
functions of underwriting, marketing and pricing new issues.
f. Stock split- A stock split takes place when a company divides its existing shares
into multiple shares to reduce the value for every share held suck that they
become easily marketable. Although the number of shares increases by a
specific multiple, the total monetary value of the shares remains the same
compared to pre-split amounts because the split didn’t add any real value.
Choosing between sources of equity
The factors to be considered when choosing between sources of equity finance
are:
1. Accessibility of the finance
2. Amount of finance
3. Costs of the issue procedure
4. Pricing of the issue
5. Control
6. Dividend policy
1. Accessibility of the finance- The ability of a company to raise the equity
finance is restricted by its access to the general market for funds. Thus, whilst
quoted companies are able to use any of the sources, an unquoted company is
restricted to rights issues and private placings.
2. Amount of finance- The amount of finance that can be raised by a right issue
from an unquoted company is limited by the number and resources of the
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existing shareholders. It is not possible to provide general estimates of the
amounts that may be raised as the circumstances vary. For quoted companies,
where rights may be sold, this is less problematic.
3. Costs of issue procedure- The issue costs associated with each source of
equity will influence the decision where use of internally-generated funds is the
cheapest and public offers the most expensive. However, all new shares issues
will take management and administrative time within the company. This will be
much greater for an offer for sale than for the other two alternatives.
4. Pricing of the issue- One of the most difficult problems in making a new issue
to the public is setting the price correctly. If it is high, the issue will not be fully
taken up and will leave with the underwriters. If it is under-priced some of the
benefits of the project for which the finance is being raised will accrue to the
new shareholders and not to the old. This will determine the amount of funds
that will be raised through the equity issue.
5. Control- The impact on the control structure could be affected by the sources
of equity. Internally-generated funds and rights issue will not affect the control
pattern while issue to the public will result in diversification of control. It is
preferable depends on the objectives of the fund-raising exercise. If the desire is
to retain control for the existing shareholders, then a rights issue is preferable. If
diversification of control is desired, then an issue to the public will be preferred.
6. Dividend policy- Using retained earnings could impact the future share price.
Long-term Finance Debt
A bond is a written acknowledgement of a debt by a company, normally
containing provisions as to payment of interest and the terms of repayment of
principal. Bonds are also known as debentures, loan notes or loan stock.
Different types of bonds-
Deep discount bonds- These are loans notes issued at a price that is a large
discount to the nominal value of the notes, and which will be redeemable at
nominal value when they eventually mature.
Zero coupon bonds- These are bonds that are issued at a discount to their
redemption value but no interest is paid on them.

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Convertible loan note- They give the holder the right of the loan note to convert
to other securities, normally ordinary shares at either a predetermined price or
a predetermined ratio.
Loan notes with warrants- Warrants give the holder the right to subscribe at a
fixed future date for a certain number of ordinary shares at a predetermined
price. The loan notes are not converted into equity.
Long-term finance: leasing
Long term lease arrangements would be used as debt finance for assets that
have a useful life over the medium to long-term period.
Conditions Long-term lease
Lease period One lease exists for the whole useful life of the asset
though may be a primary and secondary period
Lessor’s business The lessor does not usually deal directly in this type of
asset.
Risks and reward The lessor does not retain the risks or rewards of
ownership. Lessee responsible for repairs and
maintenance.
Cancellation The lease agreement cannot be cancelled. The lessee
has a liability for all payments.

Ventures Capital
Ventures capital is a form of private equity and a type of financing that investors
provide to start-up companies and small businesses that are believed to have
long-term growth potential.
Venture capitalists will assess an investment prospect on the basis of its:
➢ Financial outlook
➢ Management credibility
➢ Depth of market research
➢ Technical abilities
➢ Degree of influence
➢ Exit route

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Financial impact of sources of financial for small and medium enterprises
The main issues faced by SMEs are:
1. Funding gap
2. Maturity gap
1. Funding gap-
It is the gap between the finance available to SMEs and the finance that they
could productively use for investments. Typically, small firms rely on finance from
retentions, rights issues and bank borrowings. As a result, a funding gap often
arises when they want to expand beyond these means of finance but are not
ready for a listing on the stock exchange or alternative investment market.
2. Maturity gap-
It occurs when the maturity of the asset invested differs from the maturity of the
liabilities utilised to fund the asset in the business. The fact that medium term
loans are hard to obtain is a well-known feature of SMEs and is known as the
maturity gap. Its main problems in a mismatching of assets and liabilities.
Ways to bridge Funding Gap
1. Financial investors-
➢ Business angels- high net-worth private individuals usually with business
experience, who directly invests part of their assets in new and growing
private businesses in return for ownership equity.
➢ Venture capitalists
2. Various government solutions including-
➢ Increasing the marketability of shares- Through the development of small
firm capital markets for SEMs to raise finance.
➢ Providing tax incentives
➢ Other specific forms of assistance like grants, training loans, guarantees,
etc.
3. Other practice including-
➢ Supply chain financing- allows large organisations to vouch for their
supplier’s incomes and act as a guarantee for banks to give credit.
➢ Crowdfunding- raising finance by asking a large number of people each for
a small amount of money.

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 ➢ Peer-to-peer financing- the practice of borrowing and lending money
between unrelated individuals or peers without going through a
traditional financial intermediary such as a bank or other traditional
financial institution.
Islamic Finance
Islamic finance has the purpose as other forms of business finance except that it
operates in accordance with the principles of Islamic law.
The basic principles covered by Islamic finance include:
➢ Sharing of profits and losses
➢ No interest allowed
➢ Finance is restricted to islamically accepted transactions i.e. No
investment in alcohol, gambling, etc.
Therefore, ethical and moral investing is encouraged.
Instead of interest being charged, returns are earned by challenging funds into
an underlying investment activity which will earn profit. The investor is rewarded
by a share in that profit, after a management fee is deducted by the bank.
Sources of Islamic Finance
The main sources of Islamic finance within the Islamic banking model include:
1. Murabaha (Trade credit)
2. Ijara (Lease finance)
3. Sukuk (Debt finance)
4. Mudaraba (Equity finance)
5. Musharaka (Venture capital)
1. Murabaha (Trade Credit)-
The bank will take actual constructive or physical ownership of the asset and
then the asset is sold onto the ‘borrower’ for a profit which they will pay the
bank over a set number of instalments. The key distinction between a Murabaha
and loan is that with a Murabaha, the bank will take actual constructive or
physical ownership of the asset. The period of the repayments could be
extended but no penalties or additional mark-up may be added by the bank.
Early payment discounts are not welcomed although the financier may choose
to give discounts.

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2. Ijara (Lease finance)-
The bank makes available to the customer the use of assets or equipment such
as plant, office automation or motor vehicles for a fixed period and price. It is
the equivalent of lease finance. It is defined as when the use of the underlying
asset or service is transferred for consideration. Some of the specifications of an
ijara contact include:
➢ The use of the leased asset must be specified in the contract
➢ The lessor is responsible for the major maintenance of the underlying
assets
➢ The lessee is held for maintaining the asset in good shape
3. Sukuk (Debt finance)-
Islamic bonds are linked to an underlying asset, such that a sukuk-holder is a
partial owner in the underlying assets and profit is linked to the performance of
the underlying asset. Key features of these debt instruments are they:
➢ Don’t give voting rights in the company
➢ Give right to profits before distribution of profits to shareholder
➢ May include securities and guarantees over assets
➢ Include interest based elements.
All of the above are prohibited under Islamic law.
4. Mudaraba (Equity finance)-
The mudaraba is a contract with one party providing 100% of the capital and
other party providing its specialist knowledge to invest the capital and manage
the investment project. Profits generated are shared between the parties
according to a pre-agreed ratio while the losses are borne only by the lender of
the money. It is a special kind of partnership where one partner gives money to
another for investing it in a commercial enterprise. The investment comes from
the first partner while the management and work is an exclusive responsibility
of the other.
5. Musharaka (Venture capital)-
Musharaka is a relationship between two or more parties, who contribute capital
to a business and divide the net profit and loss pro-rate. The profit is distributed
among the partners in pre-agreed ratios, while the loss is borne by each partner
strictly in proportion to their respective capital contribution. It is most closely

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with the venture capital. All providers of capital are entitled to participate in
management but are not required to do so.

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