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Introduction 1. Business concern needs finance to meet their requirements in the economic world.

Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfill their business activities. In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity. Finance can be needed for a variety of different reasons, which will have an effect on what the most appropriate sources of finance will be. Finance could be needed for:

Starting up a new business Coping with a cash flow problem Buying some new equipment or machinery Setting up a new plant Buying another business (a takeover or acquisition) Coping with debts

Meaning of Finance 2. Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns. 3. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern. Definition of Finance 4. 5. According to Khan and Jain, Finance is the art and science of managing money. According to Oxford dictionary, the word finance connotes management of money.

6. Websters Ninth New Collegiate Dictionary defines finance as the Science on study of the management of funds and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities. Definition of Business Finance

7. According to the Wheeler, Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise. 8. According to the Guthumann and Dougall, Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business. 9. In the words of Parhter and Wert, Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in nonfinancial fields of industry. 10. Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment. 11. According to the Encyclopedia of Social Sciences, Corporation finance deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion, and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties. Financial Needs of a Business 12. Business enterprises need funds to meet their different types of requirements. All the financial needs of a business may be grouped into the following three categories:(a) Long Term Needs. Such needs generally refer to those requirements of funds which are for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etc are considered as long term financial needs. Funds required to finance permanent or hard core working capital should also be procured for long term sources. (b) Medium Term Financial Needs. Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such expenses may be written off over a period of 3-5 years. These are called defferd revenue expenses and funds required for them are classified in the category of medium term financial needs. (c) Short Term Financial Needs. Such type of financial needs arise to finance in current assets such as stock, debtors, cash etc. Investment in these assets is known as meeting of working capital requirements of the concern. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period i.e one year.

Types of Finances 13. The need for finance may be for long-term, medium-term or for short-term. Financial requirements with regard to fixed and working capital vary from one organization to other. To meet out these requirements, funds need to be raised from various sources. Some sources like issue of shares and debentures provide money for a longer period. These are therefore, known as sources of long-term finance. On the other hand sources like trade credit, cash credit, overdraft, bank loan etc. which make money available for a shorter period of time are called sources of short-term finance. In this lesson you will study about the various sources of short-term finance and their relative merits and demerits. Short Term Finance 14. This refers to money that is needed to finance activities that are usually going to last less than one year. Such finance is generally used to manage the day to day operations of a business. Purpose of Short-term Finance 15. After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short-term funds may even lead to closure of business. Short-term finance serves following purposes (a) It facilitates the smooth running of business operations by meeting day to day financial requirements. (b) It enables firms to hold stock of raw materials and finished product.

(c) With the availability of short-term finance goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business. (d) Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.

Sources of Short-term Finance

16. Short-term funds are also required to allow flow of cash during the operating cycle. Operating cycle refers to the time gap between commencement of production and realization of sales. There are a number of sources of short-term finance which are listed below: (a) (b) (c) (d) (e) Trade Credit Bank Credit Customers Advances Installment Credit Loans from Co-operative Banks

Trade Credit 17. Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment.. e.g Hill Farm Furniture is a small business based between Nottingham and Lincoln. The business makes high quality kitchen furniture. The vast majority of the work done by the business is strictly to order and made to suit the specific requirements of the customer. Hill Farm use wood - lots of it! When they receive a delivery from their supplier they do not pay straight away. They will receive a 28 day period before having to settle the bill. For many small firms, this effectively means they are getting some funds for free. Assume that the bill for a delivery of wood comes to 8,000 for Hill Farm. If they have 28 days before they have to pay they have effectively received a loan of 8,000 from their supplier for 28 days - interest free. This gives the business the time to be able to manage their finances and balance their cash flows more effectively. If a business did not pay the debt after the 28 days has past then there might be a penalty to pay. The supplier might charge a fee or start charging interest or even take the business to court to get its money back. Non payment of debts like this can cause businesses - especially small businesses - real problems. If they are not receiving money for the goods they have supplied they cannot pay their own debts. This is quite a popular source of finance Bank Credit 18. Commercial banks grant short-term finance to business firms which is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in installments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills. (a) Loans. When a certain amount is advanced by a bank repayable after a specified period, it is known as bank loan. Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. (b) Cash Credit. It is an arrangement whereby banks allow the borrower to withdraw money upto a specified limit. This limit is known as cash credit limit. Initially this

limit is granted for one year. This limit can be extended after review for another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit. Banks ask for collateral security for the grant of cash credit. In this arrangement, the borrower can draw, repay and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. (c) Overdraft. Most businesses have an account with a bank. The bank deals with all the deposits (money put into the account) and withdrawals (money taken out). Most banks know that businesses do not always receive money from sales straight away. If you run a sandwich bar in a local trading estate then you might get money straight away when you sell your sandwiches. If you are a business selling electrical equipment to an electrical retailer then you may not get paid straight away when you deliver your goods. When differences occur in the money a business receives from sales (its revenue or turnover) and the money it has to pay out on labour, machinery, equipment, distribution and so on (its costs) the firm can face difficulties. The money flowing into a business from sales and the amount it spends on costs that go out of the business is called its cash flow. A business might need to pay a bill on the 28th November for Rs15,00000 but not have enough money in its account to pay the bill. It might know that it is due to receive Rs 350000 from a customer on the 10th December but in the meantime it has a cash flow problem. This is when it is appropriate to arrange an overdraft with a bank. An overdraft is an agreement with a bank to allow the business to spend money it does not have - it is a form of a loan therefore. In our example, the business might arrange for an overdraft facility of Rs 500000 with its bank. It can now pay the bill for Rs 150000 and not worry about the cheque 'bouncing'. A cheque is said to 'bounce' when the bank refuses to honour the payment. It might be returned to the business and if this happens a charge is made to the business. Not only do bounced cheques cost the business money in bank charges but the relationships with its suppliers can be damaged. Some suppliers might think twice before supplying the business with any more stock in such circumstances! Arranging an overdraft avoids this problem. The business will get charged interest on the amount they have loaned. In our example, the overdraft facility is Rs 500000. If the business only uses Rs 150000 of that limit, they only pay interest on the Rs 150000, not the whole Rs 500000. This is a key difference between an overdraft and a loan. Overdraft facilities do have their disadvantages. The interest rate on an overdraft can be quite high, especially for small firms where the risk to the bank that they might not get their money back is greater. In addition, the business is not allowed to exceed their overdraft limit. If they do the bank might refuse to pay cheques to creditors (people who are owed money) and may hit the business with a hefty charge for exceeding the limit. Overdraft facilities can be re-negotiated but if this is tried too many times, it may be a signal to the bank that a business has not got control over its finances.

(d) Discounting of Bill. Banks also advance money by discounting bills of exchange, promissory notes and hundies. When these documents are presented before the bank for discounting, banks credit the amount to customers account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill. Advantages of Bill Discounting (i) Immediate availability of cash. By discounting the bill, the drawer gets cash immediately. He does not have to wait for the payment until the expiry of credit period stated on the bill. (ii) No extra security is to be offered. Banks generally do not ask for any other security while making payment against the bill discounted. However, if a customer is interested, banks also grant him limit for discounting of bills. This limit is known as limit against discounted bills. Usually banks ask for certain security while extending this limit. Such limit is obtained when drawing of bills of exchange is almost a regular feature in business. (iii) Nature of liability for repayment. Repayment of money advanced against discounted bill is the responsibility of the drawee of bills of exchange. Banks therefore approach the drawee, who is generally the acceptor of the bill, for payment after the due date on the bill. In case the drawee does not pay or refuses to pay, the drawer or the person who got payment after discounting the bill is held responsible for payment. Disadvantages of Bill Discounting (i) Payment of interest in advance. While discounting a bill, bank deducts the discount and balance is credited in customers account. This discount is equal to the amount of interest for the remaining period of payment against the bill. Thus, a person receiving money through discounting of bill has to offer advance interest on the amount of the bill. (ii) Facility is subjected to the creditworthiness of parties involved. Banks generally extend this facility after being satisfied with the creditworthiness of different parties involved. In case of doubt, the bank may ask for some security. Thus, it is not a very easily available facility. (iii) Additional burden in case of non-payment. Bills not paid upon maturity are to be certified by Notary Public and a certain amount in the form of noting charges is paid. Thus, it becomes an additional burden.

(e) Credit Card. A credit card works very much like trade credit. If you buy something using a credit card, you will receive a statement once a month with the details of the amount spent during the last month. You then have a certain period of time to either pay the full amount or a minimum amount.

Example: James runs a sandwich bar. He gets a lot of his supplies from a cash and carry bread, cheese, margarine, beef, tuna and so on. He pays for his weekly supplies by credit card. On the 16th of each month he receives his statement. This month it is for Rs 6450. He is told that he must pay a minimum sum of Rs 5000 or the full amount by the 5th of next month. If he pays the full amount he effectively gets over a month's interest free loan. If he chooses to pay off only part of the full amount he will have to pay interest on the amount still owed. That can be expensive! Many businesses have a company credit card. It can be a useful way of managing expenses and if paid off in full can be a useful and cheap source of short term finance. (f) Lease. Most businesses have to buy equipment and machinery of some sort. Many firms have a fleet of company cars which certain staff use or vehicles that they use for distribution. There are a number of ways of buying these things. The business might go to the bank for a loan, arrange some sort of finance deal with the supplier, use cash they have in the business or arrange a lease option. A lease effectively means that the business is paying for the use of a product but do not own it. It is also called 'hiring'. A lease agreement on a van, for example, might mean that the firm pays out Rs 3500 per month for a three year lease. At the end of the three years the vehicle returns to the owner. Lease agreements can be of benefit to the firm for the following reasons: (i) It can be cheaper to arrange a lease rather than having to buy equipment outright

(ii) Leases can be very flexible - equipment might only be needed for a short time or for a particular project and so does not warrant being bought outright. (iii) The company that owns the equipment, machinery or vehicles is responsible for the maintenance and this can help reduce costs for the business. (iv) The payments made are generally fixed and will not therefore change as interest rates change. This helps business plan more effectively. Customers Advances 19. Sometimes businessmen insist on their customers to make some advance payment. It is generally asked when the value of order is quite large or things ordered are very costly. Customers advance represents a part of the payment towards price on the product (s) which will be delivered at a later date. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A firm can meet its shortterm requirements with the help of customers advances. Customers advance refers to advance made by the customer against the value of order placed. It is, thus, a part payment of the value of goods to be supplied later.



(i) Interest free. Amount offered as advance is interest free. Hence funds are available without involving financial burden. (ii) No tangible security. The seller is not required to deposit any tangible security while seeking advance from the customer. Thus assets remain free of charge. (iii) No repayment obligation. Money received as advance is not to be refunded. Hence there are no repayment obligations. (b) Demerits

(i) Limited amount. The amount advanced by the customer is subject to the value of the order. Borrowers need may be more than the a amount of advance. (ii) Limited period. The period of customers advance is only upto the delivery goods. It cannot be reviewed or renewed. (iii) Penalty in case of non-delivery of goods. Generally advances are subject to the condition that in case goods are not delivered on time, the order would be cancelled and the advance would have to be refunded along with interest. Installment Credit 20. Installment credit is now-a-days a popular source of finance for consumer goods like television, refrigerators as well as for industrial goods. You might be aware of this system. Only a small amount of money is paid at the time of delivery of such articles. The balance is paid in a number of installments. The supplier charges interest for extending credit. The amount of interest is included while deciding on the amount of installment. Another comparable system is the hire purchase system under which the purchaser becomes owner of the goods after the payment of last installment. Sometimes commercial banks also grant installment credit if they have suitable arrangements with the suppliers. Advantages and disadvantages of this system are given below:



(i) Immediate possession of assets. Delivery of assets is assured immediately on payment of initial installment (down payment). (ii) Convenient payment for assets and equipment. Costly assets and equipment which cannot be purchased due to inadequacy of long-term funds can be conveniently purchased on payment by installments.

(iii) Saving of one time investment. If the value of asset or equipment is very high, funds of the business are likely to be blocked if lumpsum payment is made. Installment credit leads to saving on one time investment. (iv) Facilitates expansion and modernization of business and office. Business firms can afford to buy necessary equipment and machines when the facility of payment in installments is available. Thus, expansion and modernization of business and office are facilitated by installment credit. (b) Disadvantages

(i) Committed expenditure. Payment of installment is a commitment to pay irrespective of profit or loss in the business. (ii) Obligation to pay interest. Under installment credit system payment of interest of obligatory. Generally sellers charge a high rate of interest. (iii) Additional burden in case of default. Sellers sometimes impose stringent conditions in the form of penalty or additional interest, if the buyer fails to pay the installment amount. (iv) Cash does not flow. Like trade credit, installment credit facilitates the purchase of asset or equipment. It does not make cash available which can be utilized for all needful purposes. Loans from Co-operative Banks 20. Co-operative banks are a good source to procure short-term finance. Such banks have been established at local, district and state levels. District Cooperative Banks are the federation of primary credit societies. The State Cooperative Bank finances and controls the District Cooperative Banks in the state. These banks grant loans for personal as well as business purposes. Membership is the primary condition for securing loan. The functions of these banks are largely comparable to the functions of commercial banks.



(i) Loans from co-operative banks are easily available to farmers and small businessmen involving minimum formalities. (ii) Co-operative banks provide a convenient means of borrowing. Loans are generally granted at a lower rate of interest. (iii) Sometimes co-operative banks organize training programmes for members to familiarize them with the various avenues of business and regarding proper utilization of loan money.

(iv) Being a member of a cooperative bank, the borrower can participate in the management and also share in the profits of the society. (v) Co-operative loans create a sense of thrift and self-reliance among the low income group.

(vi) Loans are generally given for productive purposes and that helps to develop the financial and social status of the people. (b) (i) Drawbacks Loan from co-operative banks is available only to members.

(ii) Co-operative banks find it difficult to ensure repayment of loan money due to inadequate information about the need and utilization of funds by the borrower. There is little scrutiny of the repaying capacity of the loan seeker at the time of granting loan. (iii) Inadequate resources and lack of trained personnel for management have restricted the spread of co-operative banking facilities. (iv) Co-operative banks depend largely on the support of the Government. Therefore Government rules and regulations sometime create hurdles for the borrowers. (v) Credit from co-operative banks is available only for limited purposes.

Merits and Demerits of Short-term Finance 21. Short-term loans help business concerns to meet their temporary requirements of money. They do not create a heavy burden of interest on the organization. But sometimes organizations keep away from such loans because of uncertainty and other reasons. Let us examine the merits and demerits of short-term finance. (a) Merits of Short-term Finance

(i) Economical. Finance for short-term purposes can be arranged at a short notice and does not involve any cost of raising. The amount of interest payable is also affordable. It is, thus, relatively more economical to raise short-term finance. (ii) Flexibility. Loans to meet short-term financial need can be raised as and when required. These can be paid back if not required. This provides flexibility. (iii) No Interference in Management. The lenders of short-term finance cannot interfere with the management of the borrowing concern. The management retain their freedom in decision making.

(iv) May also serve long-term purposes. Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for one year but it can be extended upto 3 years with annual review. After three years it can be renewed. Thus, sources of short-term finance may sometimes provide funds for long-term purposes. (b) Demerits of Short-Term Finance. Short-term finance suffers from a few demerits which are listed below: (i) Fixed Burden. Like all borrowings interest has to be paid on short-term loans irrespective of profit or loss earned by the organization. That is why business firms use shortterm finance only for temporary purposes. (ii) Charge on Assets. Generally short-term finance is raised on the basis of security of moveable assets. In such a case the borrowing concern cannot raise further loans against the security of these assets nor can these be sold until the loan is cleared (repaid). (iii) Difficulty of Raising Finance. When business firms suffer intermittent losses of huge amount or market demand is declining or industry is in recession, it loses its creditworthiness. In such circumstances they find it difficult to borrow from banks or other sources of short-term finance. (iv) Uncertainty. In cases of crisis business firms always face the uncertainty of securing funds from sources of short-term finance. If the amount of finance required is large, it is also more uncertain to get the finance. (v) Legal Formalities. Sometimes certain legal formalities are to be complied with for raising finance from short-term sources. If shares are to be deposited as security, then transfer deed must be prepared. Such formalities take lot of time and create lot of complications. Long Term Finance 22. Companies have different alternatives for obtaining funds that is used to finance investment project. They can issue debt or equity securities to archive this goal. Sometimes lease is also used as an alternative for long term financing. The source of finance has an implication on cost of funds. To this end this chapter discusses the different sources of finance including their merits and demerits. Definition 23. This refers to finance that is needed over a long period of time - certainly over a year and possibly over many years. It tends to be used for financing the setting up of businesses and for expansion of existing businesses. Long Term Sources of Finance

24. Long term sources of finance are those that are needed over a longer period of time generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance. 25. Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

\ Large-scale development of plant and equipment may cost millions of pounds. Long term finance is needed for this type of development. 26. It is important to remember that in most cases, a firm will not use just one source of finance but a number of sources. There might be a dominant source of funds but when you are raising hundreds of millions of pounds it is unlikely to come from just one source. Equity Financing 27. Equity securities represent ownership interest in a corporation. These securities include common stock and preferred stock. These two forms of securities provide a residential claim on the income and assets of a corporation. Thus, this section discusses these two sources of longterm finance. (a) Common Stock Financing. The common stockholders of a corporation are its residual owners; their claim to income and assets comes after creditors and preferred stockholders have been paid in full. So common stock holders assume the ultimate risk associated with the corporation. Advantage and disadvantages of common stock financing are as follows:(i) Advantages of Common Stock

Common stock does not obligate the firm to make payments to stockholders. A firm cannot be obliged to pay divided when there are financial constraints. Had it used debt, it would have incurred a legal obligation to pay interest regardless of operating condition and cash flows. Common stock has no fixed maturity date. It never has to be rapid as would a debt issue. Common stock protects creditors against losses and hence, the sale of common stock increases the creditworthiness of the firm. This in turn raises it bond rating, lowers its cost of debt and increases its future ability to use debt. One of the costs of issuing debt is the possibility of financial failure. This possibility does not arise when debt is used.


Disadvantages of Common Stock The cost of underwriting and distributing common stock is usually higher than that of preferred stock or debt If the firm has more equity than required in its optimal capital structure, its cost of capital will be higher than necessary. Therefore, a firm would not want to sell stock if the sale would cause its equity ration to exceed optimal level Under current tax laws, dividends on common stock are not deductible for tax purposes, but interest is deductible. This raises the relative cost of equity as compare to debt.

(b) Preferred Stock Financing. Preferred stock differ from common stock because it has preference over common stock in the payment of dividends and in the distribution of corporation assets in the event of liquidation. Preference means only that the holders of the preferred shares must receive a dividends (in the case of an ongoing firm) before holders of common share are entitled to anything. Preferred stock is a form of equity form a legal and tax stand point. It is important to note. However, the holders of preferred stock sometimes have no voting privilege. Preferred stock is sometimes convertible in to common stock and is often callable. So we can say that preferred stock is a hybrid form of financing combing features of debt and common stock. (i) Advantages of Preferred Stock

By using preferred stock a firm can fix its financial cost and still avoid the danger or bankruptcy if earnings are too low to meet these fixed charges. This is because preferred stock earners a dividend but the company has discretionary power to pay it. The omission of payment doesnt result in default.


Disadvantages of Preferred Stock

It has a higher after tax cost of capital that debt. The major reason for this higher cost is taxes preferred dividends are no deductible for tax purpose, whereas interest expense on debt is deductible. Debt Financing Bond 28. A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. 29. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents. Characteristics 30. Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio. (a) Face Value/Par Value. The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value. Corporate bonds normally have a par value of $1,000, but this amount can be much greater for government bonds. (b) Coupon (The Interest Rate). The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically. (c) Maturity. The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued). A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond. (d) Issuer. The issuer of a bond is a crucial factor to consider, as the issuer's stability is your main assurance of getting paid back. For example, the U.S. government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small - so small that U.S. government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through

taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors - this is the risk/return tradeoff in action. Advantages and Disadvantages of Debt Financing 31. The corporation payment of interest on debt is considered a cost of doing business and is fully tax deductible. Dividends paid to stockholders are not tax deductible. This makes debt financing a cheaper source of finance than equity financing. 32. Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the asset of the firm. This action can result in liquidation or reorganization tow of the possible consequences of bankruptcy. Thus one of the costs of issuing debt is the possibility of financing failure. This possibility does not exist when equity is issued. Lease Financing 33. Leasing is an important source of equipment financing. For some equipment, the financing is long term in nature. A lease is a contract whereby the owner of an asset (the leaser) grants to another party (the leasee) the executive right to use the asset in return for the payment of rent (i.e. lease payment). In other words, through leasing, a firm can obtain the use of certain fixed assets for which it must make a series of contractual periodic payments form the lease points of view; this lease payment is tax deductible. Here we discuss lease as an alternative source of financing and hence we shall see the effects of leasing on the lease business.

Types of Leases 34. Leases can be basically classified in to two; operating lease and capital or financial lease. An operating lease is relatively short term in length and is cancelable with proper notice. The term of this type of lease is shorter than the assets economic life. Operating leases for instance may include the leasing of copying machines certain computer hardware and word processors. In contrast to an operating lease a financial lease is longer term in nature and is noncancelable. The lessee is obligated to make lease payments until the lease term expires which approaches the useful life of the asset. 35. If an operating lease is held until the term of the lease, at the maturity date will return the leased asset to the owner (leassor) who may lease is again or sell the asset. However, if the leasee decides to return the asset before maturity (i.e. cancel the lease) it may be required to pay a predetermined penalty for cancellation. 36. In case of financial lease the leasee cannot cancel the lease contract and is obligated to make leasee payment over the term of the lease regardless of whether the leasee needs the

service of the asset or not. But at the maturity date, the lease may transfer ownership of the asset to the lessee or they may have the opportunity to purchase the leased asset at a bargain price. For capital (or financial) lease the value of asset along with the corresponding lease liability must be shown on the balance sheet. Capital leases are commonly used for leasing land, buildings and big equipment. Conditions 37. More specifically, a lease is considered as a capital (or financial) lease if it meets any one of the following conditions: (a) (b) The lease transfers title to the assets to the leasee by the end of lease period The lease contains on option to purchase the asset at a bargain price.

(c) The lease period is equal to or greater than 75 percent of the estimated economic life of the assets. (d) At the beginning of the lease the present value of the minimum lease payments equal or exceeds 90 percent of the value of the leased property of the lessor. 38. If any of the above condition is not met, the lease is classified as an operating lease. Essentially, operating leases give the leasee the right to use the leased properly over a period of time, but they do not give leasee all the benefits and risks associated with the asset.

Advantages of Leasing (a) Leasing allows the lease to deduct the total payment as on expense for tax purposes. (b) Because leasing results in the receipt of service from an asset possibly without increasing the liabilities on the firms balance sheet, it may results in favorable financing rations. (c) Leasing provides 100 percent financing as opposed to loan agreement where the purchase of the asset (borrower as well) is required to pay a portion of the purchase price as a down payment. (d) In a lease arrangement, the leasee may avoid the cost of obsolescence if the lessor fails to accurately anticipate the possibility for obsolescence of the asset and set the less payment too low. Disadvantage of Leasing (a) A lease does not have a stated interest cost. Besides at the end of the term of the lease agreement, the salvage value of an asset, if any, is realized by the leaser. Thus in many of the leases, the return to the lessor is quite high.

(b) In a lease of an asset that subsequently becomes obsolete, under a capital lease the leasee still makes lease payments until maturity. Shares 39. A share is a part ownership of a company. Shares relate to companies set up as private limited companies or public limited companies There are many small firms who decide to set themselves up as private limited companies; there are advantages and disadvantages of doing so. It is possible, therefore, that a small business might start up and have just two shareholders in the business. 40. If the business wants to expand, they can issue more shares but there are limitations on who they can sell shares to - any share issue has to have the full backing of the existing shareholders. PLCs are different. They sell shares to the general public. This means that anyone could buy the shares in the business. 41. Some firms might have started out as a private limited company and have expanded over time. There might come a time when they cannot issue any more shares to friends or family and need more funds to continue expanding. They might then decide to become a public limited company. This is called 'floating the business'. It means that the business will have to go through a number of administrative and legal procedures to allow it to be able to offer shares to the general public. 42. It might be that a business wants to raise 300 million to finance its expansion plans. It might issue 300 million 1 shares in the company. The offering of these shares has to be accompanied by a prospectus which lays out details of the business - what it is involved in, how it is structured, how it will be managed and so on. This is so that prospective investors, people or institutions who might want to buy the shares, can get information about the company before committing to buying shares. 43. Once the shares are sold, share owners can buy and sell their shares through the stock exchange. Such buying and selling does not affect the business concerned directly and is one of the main advantages of the stock exchange. There may be times in the development of a plc when it needs to raise more funds. In this case it can issue more shares. Many firms will do this through what is called a 'rights issue'. This occurs where new shares are issued but existing shareholders get the right to purchase new additional shares at a reduced price. If the business is doing well and the new finance is needed for expansion, this can be an attractive proposition for existing shareholders. For the business it is a relatively quick and cheap way of raising new funds. Debentures 44. Debenture means a document issued by the company as an acknowledgement of indebtedness to its debenture-holders and giving an undertaking to repay the debt at a specified date or at the option of the company. These are the instruments for raising long term debt capital. Debenture holders are the creditors of the company to which company pays the interest at a fixed

rate and at the intervals stated in the debenture. No voting rights are given to the debenture holders. Usually debentures are secured by charge on the assets of the company. Features 45. Following are the features of debentures:

(a) Debenture holders of the company are the creditors of the company and not the owners of the company. (b) Capital raised by way of debentures is required to be repaid during the life time of the company at the time stipulated by the company. Thus, it is not a source of permanent capital. (c) (d) (e) (f) (g) (h) Debentures are generally secured. Return paid by the company is in the form of interest which is predetermined. Debentures are very risky from companys point of view for raising long term funds. Risk on the part of debenture holders is very less. Debenture holders do not carry any voting rights. Debentures are a cheap source of funds from the companys point of view.

Advantages of Debentures 46. The Advantages of Debentures are as follows:

(a) The holders of the debentures are entitled to a fixed rate of interest. It can be presented as "5% Debenture". (b) Debentures are for those who want a safe and secure income as they are guaranteed payments with high interest rates. (c) They have priority over other unsecured creditors when it comes to debt repayment. Disadvantages of Debentures 47. Disadvantages of debentures are as follows:

(a) Unlike ordinary shares, debenture holders are not considered the owners of the company. They are long term loan capital and holders will have no right to vote at the annual general meeting.

(b) Debentures are more secure than stocks, but will lead to a lower rate of theoretical return. (c) It is a type of debt instrument which is not secured by collateral (or physical asset). In case of bankruptcy, the bond holders are given priority over the debenture holders. Venture Capital Funding 48. Venture Capital is a form of "risk capital". In other words, capital that is invested in a project (in this case - a business) where there is a substantial element of risk relating to the future creation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loan and the investor requires a higher rate of return" to compensate him for his risk. 49. The main sources of venture capital in the UK are venture capital firms and "business angels" - private investors. Separate Tutor2u revision notes cover the operation of business angels. In these notes, we principally focus on venture capital firms. However, it should be pointed out the attributes that both venture capital firms and business angels look for in potential investments are often very similar. 50. Venture capital provides long-term, committed share capital, to help unquoted companies grow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-out a business in which he works, turnaround or revitalize a company, venture capital could help do this. Obtaining venture capital is substantially different from raising debt or a loan from a lender. Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the success or failure of a business. Venture capital is invested in exchange for an equity stake in the business. As a shareholder, the venture capitalist's return is dependent on the growth and profitability of the business. This return is generally earned when the venture capitalist "exits" by selling its shareholding when the business is sold to another owner. What kinds of businesses are attractive to venture capitalists? 51. Venture capitalists prefer to invest in "entrepreneurial businesses". This does not necessarily mean small or new businesses. Rather, it is more about the investment's aspirations and potential for growth, rather than by current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a venture capital firm. Venture capital investors are only interested in companies with high growth prospects, which are managed by experienced and ambitious teams who are capable of turning their business plan into reality. For how long do venture capitalists invest in a business? 52. Venture capital firms usually look to retain their investment for between three and seven years or more. The term of the investment is often linked to the growth profile of the business. Investments in more mature businesses, where the business performance can be improved

quicker and easier, are often sold sooner than investments in early-stage or technology companies where it takes time to develop the business model. Bank Loans 53. As with short term finance, banks are an important source of longer term finance. Banks may lend sums over long periods of time - possibly up to 25 years or even more in some cases. The loans have a rate of interest attached to them. This can vary according to the way in which the Bank of England sets interest rates. For businesses, using bank loans might be relatively easy but the cost of servicing the loan (paying the money and interest back) can be high. If interest rates rise then it can add to a businesss costs and this has to be taken into account in the planning stage before the loan is taken out. Mortgage 54. A mortgage is a loan specifically for the purchase of property. Some businesses might buy property through a mortgage. In many cases, mortgages are used as a security for a loan. This tends to occur with smaller businesses. A sole trader, for example, running a florists shop might want to move to larger premises. They find a new shop with a price of 200,000. To raise this sort of money, the bank will want some sort of security - a guarantee that if the borrower cannot pay the money back the bank will be able to get their money back somehow. 55. The borrower can use their own property as security for the loan - it is often called taking out a second mortgage. If the business does not work out and the borrower could not pay the bank the loan then the bank has the right to take the home of the borrower and sell it to recover their money. Using a mortgage in this way is a very popular way of raising finance for small businesses but as you can see carries with it a big risk. Owner's Capital 56. Some people are in a fortunate position of having some money which they can use to help set up their business. The money may be the result of savings, money left to them by a relative in a will or money received as the result of a redundancy payment. This has the advantage that it does not carry with it any interest. It might not, however, be a large enough sum to finance the business fully but will be one of the contributions to the overall finance of the business. Retained Profit 57. This is a source of finance that would only be available to a business that was already in existence. Profits from a business can be used by the owners for their own personal use (shareholders in plcs receive a share of the company profits in the form of a dividend - usually expressed as Xp per share) or can be used to put back into the business. This is often called 'ploughing back the profits'. 58. The owners of a business will have to decide what the best option for their particular business is. In the early stages of business growth, it may be necessary to put back a lot of the profits into the business. This finance can be used to buy new equipment and machinery as well

as more stock or raw materials and hopefully make the business more efficient and profitable in the future. Selling Assets 59. As firms grow they build up assets. These assets could be in the form of property, machinery, equipment, other companies or even logos. In some cases it may be appropriate for a business to sell off some of these assets to finance other projects. 60. In October 2006, the Thomson Corporation announced that it would be selling Thomson Learning. Part of the reasoning was that the learning part of the business was different to other parts of the corporation and that it did not fit into the strategic direction which the corporation as a whole wanted to go in. Selling Thomson Learning will help to raise valuable funds for the rest of the corporation to be able to develop. It is estimated that Thomson Learning will be worth something in the region of 5 billion! Lottery Funding 61. In the UK the National Lottery might be a possible source of funds for some types of business. These businesses will mostly be charities or charitable trusts. The Eden Project, referred to earlier, received some funding from the Lottery. The company that run the Eden Project are a not for profit business so any surplus they make is put back into the business to help develop and improve it.

Conclusion Firms have different alternative sources of long term finance including equity debt and lease. Equity financing could simply mean raising long term funds by selling common or preferred stock. Debt financing can be through the issuance of debt securities like bonds. In lease financing the leasee agrees to pay the periodically for the use of leasers assets. Because of this contractual obligation leasing is regarded as a method of financing similar to borrowing. There are two types of lease agreements. These are operating lease and capital (or financial lease). The principal factor affecting the decision to use equity or bond financing is tax. Dividends on equity are not tax deductible whereas interest on debt is deductible. This raises the relative cost of equity compared to debt. 7