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BUSINESS

FINANCE

CHAPTER 15
CHAPTER OVERVIEW

Why businesses need capital to start up, to expand or to pay for


day-to-day expenses (working capital)
How the legal structure of a business affects its ability to raise finance
The distinction between different sources of finance short- and
long-term, internal and external
The factors that influence a businesses choice of sources of finance
WHY
BUSINESSES
NEED CAPITAL
15.1
KEY TERMS

Capital
The money invested into a business either by its owners or by organizations such as banks
Usually used to purchase assets
Share capital
The money invested into a company by shareholders when they buy shares
Loan Capital
Money invested by a business as a result of borrowing
Asset
Any item owned by a business that can generate income for the enterprise
Non-current assets
Assets that a business expects to hold for one year or more
Property, vehicles, equipment, investment in other firms, etc.
WHY BUSINESSES NEED
CAPITAL
Capital is the money invested into a business either by its owners or
by organizations such as banks
Usually used to purchase assets
There are two major circumstances in which a business needs to raise
capital:
1. When it is first started
Referred to as start up capital
Likely to be small as an entrepreneur starting a new business is unlikely
to have access to large amounts of finance
Banks and investors may be unwilling to invest in an untried enterprise
Typically used to purchase assets needed to begin trading
WHY BUSINESSES NEED
CAPITAL
Many new businesses will use capital to purchase non-current assets
Most will finance market research, promotion, establishing brand identity
Needs for capital differ depending on the business
A manufacturing business
Buy a lease for a factory for an agreed upon period of time
Will also need to buy machinery and vehicles
Start-ups supplying services
Purchase leases on shops or offices

Non-current assets
Assets that a business expects to hold for one year or more
Property, vehicles, equipment, investment in other firms, etc.
CASE STUDY: CREATING A
STORM OF INTEREST
1. Explain how an entrepreneur starting a new business as a company
might raise the capital needed to start the business.
Might create a private company allowing the firm to sell shares
May have friends or family invest
2. Discuss the reasons why Key is Ng was able to start the Storm
Creative Events Agency with so little start-up capital.
It provides a service and will not need to purchase lots of non-current
assets
May only require a small staff and would not need to invest in much
training
WHY BUSINESSES NEED
CAPITAL
2. When it expands
Increase sales of existing products
Enter new markets
Develop new products
Take over another business
SOURCES OF FINANCE FOR
START-UPS AND EXPANSION
Start-up capital Capital for expansion
Possible sources of finance include: Possible sources of finance include:
owners finance: savings, sale of shares (possibly using a
redundancy pay, etc. Stock Exchange)
money borrowed from friends sale of non-current assets that are
and family not used
bank loans loan capital banks may be willing
funds invested by outsiders, for to lend for expansion
example, venture capitalists. profits retained in the business
from previous trading periods.
USES AND SOURCES OF
FINANCE
Loan capital
Raised from financial organizations such as banks
If a firm is expanding they are more likely to get a loan as they will have a track
record of successful trading and an established customer base
The business will also have assets to use as collateral

Share capital
Funds raised in exchange for an ownership interest in the company in the form
of shares
Easier for large firms trading on the Stock Exchange
USES AND SOURCES OF
FINANCE
Retained profits
Can only be used if a company is established and profitable
Not available for start-up businesses

Venture capital
Investments from wealthy individuals or organizations
Normally offered as a mix of loan and share capital
Unlikely to provide large sums of finance
Typically used by start-ups
WORKING
CAPITAL
15.2
WORKING CAPITAL

Working capital is the cash a business has for day-to-day spending


Essential to keep the business operating
What remains of a businesss liquid assets once it has settled all
immediate debts

To calculate working capital:


Working Capital = Current Assets - Current Liabilities
MATH MOMENT

1. Calculate its working capital for last year.


A$25.0 million A$19.9 million = A$5.1 million
2. This year its current assets fell by 5% while its current liabilities
rose by A$1.1 million. Calculate its working capital this year.
New current assets = A$25.0 million x 0.95 = A$23.75 million
New current liabilities = A$19.9 million + A$1.1 million = A$21.0 million
Working capital = A$23.75 million A$21.0 million = A$2.75 million
WORKING CAPITAL AS A
SOURCE OF FINANCE
Extremely important to all businesses
Described as the lifeblood of a successful enterprise
If a business cannot pay bills promptly then it may be forced to close
down
Can also be a source of finance
To have a strong working capital position a firm will need to:
Make sure its debtors pay on time
Ensure it doesnt hold too high inventory levels
Pay its own debts as late as possible
If its current assets exceed its current liabilities on a regular basis it
can be a potential source of short-term finance
CASE STUDY: MEO AUSTRALIA RAISES
A$9.3 MILLION FOR WORKING CAPITAL

1. Why might MEO Australia need large amounts of working capital?


Must finance production long before it receives any returns from the sale
of its fuel products
Must cover the time between outflows and inflows
MEO is expanding rapidly and needs to purchase additional resources to
increase production
REVENUE
EXPENDITURE
AND CAPITAL
EXPENDITURE
15.3
REVENUE EXPENDITURE AND
CAPITAL EXPENDITURE
If a start-up or expansion is successful it will earn revenue from its
sales.
Will be used to buy more labor services and raw materials in order to
continue trading
The expenditure can be divided in two categories
1. Revenue expenditure
Items that will be used up in a short space of time such as fuel, wages or
raw materials
Will be shown on a businesss income statement
2. Capital expenditure
Money spent on non-current assets such as land, buildings, or equipment
Will be shown on a businesss statement of financial position
CASE STUDY: VARDHMAN
TEXTILES
1. Using examples, explain the difference between revenue and capital
expenditure.
Capital expenditure is spending on non-current assets.Vardhman would
have to purchase machinery and a factory
Revenue expenditure refers to the purchase of materials used in a short
space of time. Vardhman would purchase raw materials such as cotton
2. Evaluate the view that this capital expenditure will increase the
profits earned by Vardhman Textiles.
It will increase its ability to manufacture and sell products
The use of machinery may result in more efficient production
SOURCES OF
FINANCE
15.4
SOURCES OF FINANCE

Choosing a source of finance will depend on


Amount of money required
Purpose for the required finance
Period of time over which the loan is required
Legal structure of the business
Financial position of the business
SHORT- AND LONG-TERM
SOURCES OF FINANCE
Short-term sources of finance
Needed for a limited period of time, normally less than one year
Used to pay bills, purchase raw materials, pay wages and salaries, etc.
Typically needed when customers are late on paying or if sales are
unexpectedly low
Sudden increases in the cost of raw materials can also create a need
Usually repayable within a one-year period
Working capital, retained profits, overdrafts
SHORT- AND LONG-TERM
SOURCES OF FINANCE
Long-term sources of finance
Typically used to purchase major capital assets such as land and buildings
Will be repaid over a period of time in excess of one year
Retained profits, sale of assets, sale and leaseback, bank loans, etc.
INTERNAL SOURCES OF
FINANCE
Exists within the business
Retained profits
Use profits from current or previous years as sources of finance
Avoids paying interest on a loan or selling company shares
A major source of finance, especially for smaller businesses
Can have substantial opportunity costs as it takes away from investing in
other ways
Shareholders might not be happy as they will likely receive lower
dividends
Only available if a firm made a profit
INTERNAL SOURCES OF
FINANCE
Sale of unwanted assets
Normally non-current assets such as land, buildings, etc.
Company benefits as it is not committed to future interest payments
Shareholders benefit as there isnt dilution of control or less dividends
Sale and leaseback
Sell valuable assets and then lease them again to continue using
Earn capital from the sale
Now must pay for the use of the assets and may have a negative impact
on long-term profits
CASE STUDY: THE THOMAS
COOK GROUP
1. Explain why the Thomas Cook Group might have wanted to reduce
the amount of debt (or borrowing) that it had.
Paying interest on loans can result in lower profits. Interest payments can
become a burden if the company has high levels of debt and interest rates
are rising
May consider expansion and want to sell shares to do this. In order to be
an attractive investment it wont want to have lots of debt
2. Evaluate whether sale and leaseback is the best choice as a source
of finance for Thomas Cook Group plc in these circumstances.
Provides relatively quick source of finance and doesnt depend on approval
by a bank
Results in additional cash outflows which may reduce profitability
INTERNAL SOURCES OF
FINANCE
Working capital
Cash required to pay for day-to-day operations
Pay for things such as fuel, raw materials, wages, etc.
Reducing inventory levels, chasing up debtors and delaying payment to
suppliers can raise cash
May seek to improve trade terms
Instead of 30 days of interest free credit, try to extend to 60 days
May lead to no discounts on selling prices
EXTERNAL SOURCES OF
FINANCE
Comes from individuals, other businesses, or organizations such as
banks
More likely to be used when:
A large sum of finance is required
Too difficult to raise internally
The level of risk associated with the source of finance is low
The companys profit levels are relatively low
Unable to use retained profits
EXTERNAL SOURCES OF
FINANCE
Overdrafts
Perhaps the best known method of short-term finance
An overdraft is an extension of credit from banks when an account reaches
zero
An overdraft allows the business to continue withdrawing money even if the
account has no funds in it or not enough to cover the withdrawal
High interest rates are charged and can be quite expensive in the long-term
Bank loans
Relatively straightforward to arrange if the business is solvent and has a
satisfactory financial history
Advancement of set amount to be repaid over an agreed upon time
If the bank sees it as a risky investment, it will charge higher interest rates
Small businesses especially suffer from this
Banks will often require security or collateral usually in the form of property
If the business defaults the bank can sell the property to recoup its investment
EXTERNAL SOURCES OF
FINANCE
Mortgages
Long-term loans (often up to 50 years) from financial institutions solely for
land or buildings
The land/building acts as collateral if the business cannot make payments
Fixed or variable rates of interest
Suitable when a business wishes to raise large sums of money
Debentures
Special type of long-term loan normally to be repaid within 15 years
Fixed interest rates
Some dont have a repayment date and act as permanent loans
Secured by using non-current assets as collateral
Another form of loan capital and holders do not have voting rights in the
business
CASE STUDY: EVEN BANKS
NEED TO RAISE CAPITAL
1. Explain the advantages and disadvantages of borrowing a large sum
of capital as Bank CIMB Niaga has done.
By issuing a bond as a form of loan it increases certainty. The bank knows
precisely the sum it will raise as well as the timing and amounts it has to
repay
Financing this way means a loan of $200 million at an average interest rate
of approx. 7.5%, would lead to annual repayments of $15 million
2. Discuss the other sources of finance that might be available to a
large bank such as CIMB to provide funds to lend to customers.
As a public company, it can sell shares
Likely to own a number of properties it could sell and leaseback
Reinvest past profits
EXTERNAL SOURCES OF
FINANCE
Venture capital
Important for small- to medium-sized businesses which are considered
risky
Normally a mix between a loan and share capital
Generally comes from well-off investors, merchant banks, wealthy
individuals (business angel investors)
Will wish to have some control over the organization
Also provide experience, contacts, advice, etc.
Typically wont advance huge amounts of money
Though providing venture capital can be risky, the potential for above-
average returns is an attractive payoff
EXTERNAL SOURCES OF
FINANCE
Share or equity capital
Common for start-ups and additional capital in the later stages of a
businesss life
Raised by selling shares in the business to investors
Issuing shares can be expensive and would only be appropriate for raising
large sums of capital
Available to private and public limited companies
Easier for public limited companies because:
1. They can sell shares on the stock exchange
2. Dont need permission of the other shareholders (as in private limited)
An added benefit is that even though the company is expected to pay
annual dividends, it is not fixed
If the year is unprofitable the company can avoid making any payments
CASE STUDY: CHINESE MINING
COMPANY NEEDS CAPITAL
1. Explain the factors that China Polymetallic Mining (CPM) would
take into account when deciding on the best source of finance to
use for its planned expansion.
The extent to which it could use its past profits
Analyzed the likely returns from expanding into Myanmar
2. To what extent is selling shares the best way for China Polymetallic
Mining (CPM) to raise capital to fund its expansion.
Avoids the need to pay fixed rates of interest
Avoids the need to borrow money and increase debt
If it sells too many shares the existing management may lose control
EXTERNAL SOURCES OF
FINANCE
Microfinance
Financial services for poor and low-income clients
Includes small loans, savings, transferring money, insurance, etc.
Supports the transfer of remittances of income from those earning
reasonable incomes to poorer relatives/friends in other countries
Money sent home by migrants competes with international aid as one of the
largest financial inflows to developing countries
Helps fund activities which create incomes, build assets and protect
against risk
Seen as a solution to reducing poverty
CASE STUDY:
LENDWITHCARE
1. Explain why banks in Ecuador might be unwilling to lend Maria
$2,000.
They doubt her ability to repay it and the banks may lose their investment
May not traditionally lend to small entrepreneurs
2. Discuss the arguments for and against lending Maria a small sum of
money.
Maria might not be able to offer any security for a loan and may not be able
to repay it
Would not be too big of a risk as its a relatively small sum of money
EXTERNAL SOURCES OF
FINANCE
Crowdfunding
Collecting relatively small amounts of money form a large number of
supporters
Has become extremely popular in recent years especially with small- and
medium-sized businesses
In 2015, it was estimated that over US$34 billion was raised
Avoids the need to deal with local banks and paying interest rates
EXTERNAL SOURCES OF
FINANCE
Government grants
Money given for a specific purposeexpansion, research, development,
etc.
Will usually only cover a portion of the total costs as there is a fixed
amount available
Likely to be a great deal of competition from other businesses
Do not have to be repaid as long as all conditions are met
UK examples include:
SFI grants which is for capital expenditure for start-up costs and expansion.
Only given if jobs are created for only for a maximum of 15% of total
investment
Technology grants available for R&D, marketing new tech-based products, or
developing renewable energy sources
MATH MOMENT

1. How much was the start-up cost of the new business?


375,000 x 100 / 15 = 2,500,000
TAKING ON NEW PARTNERS

An option for small- and medium-sized enterprises

A partnership will invest in the enterprise and own a share of the


business
May include limited liability

A private limited company can decide to sell more shares


Existing shareholders must support the decision
Provides an injection of capital
CASE STUDY: CROWDFUNDING:
A DIFFERENT SOURCE OF
FINANCE
1. Explain why a loan from the bank might have been George
Christakos first source of finance.
He owns and manages a reputable business and he may expect a bank to
grant a loan as his record suggests he understands the business and would
make repayments
He has assets to use as collateral for his loan
2. Discuss the major advantages and disadvantages of using
crowdfunding as a source of finance.
It is relatively cheap as those investing only put in a small amount and may
not be motivated by seeking high profits
Helps in gaining publicity along with finance
May be effective only in certain circumstances
FA C T O R S
INFLUENCING THE
CHOICE OF
SOURCES OF
FINANCE
15.5
THE BUSINESSS LEGAL
STRUCTURE
Major influence on sources of finance available to a business

Public and private limited companies can sell shares


Only public companies can sell on stock exchanges

Start-ups (most likely sole proprietorship or partnerships) have a


more limited range of sources
Represent a greater risk for investors
Have few, if any, internal sources to use
COST OF THE SOURCE OF
FINANCE
Rate of interest
The rate of interest charged by banks, etc. granting loans can be a significant
influence
If it is a large loan or high risk, the rates will be higher
A short-term loan to a high risk business might be charged at a high rate of
interest
Cost of selling shares
May be attractive option for public limited companies
Can be expensive in terms of administrative costs, promotion, insurance, etc.
Will sometimes use rights issues to sell new shares to existing shareholders
in proportion to the number already owned
Offer one new share (possibly at discount) for every eight already owned
COST OF THE SOURCE OF
FINANCE
Selling shares
New shares are issued directly to shareholders
Second-hand shares are sold mainly through stock exchanges
Not a source of finance for the company
The shareholder is recovering their investment by selling the shares to
another person or organization
CASE STUDY: PAKISTANS
CEMENT INDUSTRY FACES HIGH
BORROWING COSTS
1. Explain the benefits that Pakistani cement producers might receive
from issuing shares as a means of raising capital.
Not having to borrow money and having to pay interest
2. Discuss the reasons why high interest rates have been such a
burden for businesses in the cement industry in Pakistan.
The industry is in a weak financial position and is not well equipped to pay
high interest rates
Will have to make substantial payments over a long period of time
The market for cement is losing demand
COST OF THE SOURCE OF
FINANCE
Opportunity Cost
The next best alternative foregonewhat has to be given up as a
consequence of the decision
A sale and leaseback appear a low-cost option, this has committed the
company to paying each month or year for the asset that was sold
Using retained profits for reinvestment avoids paying interest but reduces
amount of dividends paid to shareholders
Flexibility
Some are highly flexible and can be adapted to meet precise needs
Overdrafts allow for overspending with interest charges but is expensive
Government grants are appealing because they are normally not repaid
Inflexible as they usually come with very strict conditions, rules and
regulations
COST OF THE SOURCE OF
FINANCE
Control
Some sources may result in the original owner losing some or complete
control
Some sources are only available if investor gains a say in how the
business is managed
Most obvious when selling sharessell more than 50% and you lose
control
Can possibly sell shares without full voting rights allowing original
shareholders to retain control
This is less attractive to potential new investors

Smaller businesses can also lose a degree of control


VCs may only invest if they have a say in the management of the business
THE PURPOSES FOR WHICH
THE FINANCE IS NEEDED
Some sources are available in certain situations
A business seeking to purchase property will consider a mortgage
Long-term and possible low interest rates make it an ideal source
For a risky start-up a VC might be the best choice
Difficult to find other investors and VCs specialize in this
To fund expansion will need additional working capital
Overdraft or trade credits may be selected as only short-term funding is
needed
THE LEVEL OF EXISTING DEBT

If a business has a lot of debt it will be increasingly difficult to get


more financing
Further loans will represent a risk

May have to seek alternative sources


Selling assets (and possibly leasing it back)
Selling shares

A general rule states that if a business has borrowed more than half
the total capital raised, further loans are too risky for banks
CHOOSING AN
APPROPRIATE
SOURCE OF
FINANCE
15.6
CHOOSING AN APPROPRIATE
SOURCE OF FINANCE
When making judgements on the most appropriate source, managers
will have to consider a range of factors:
The businesss financial situation
Is the business profitable? If so it can used retained profits as a source of
finance
Can be used to provide evidence to banks and other creditors that it
can repay loans

Creditors are individuals or organizations to whom the business owes


money
CHOOSING AN APPROPRIATE
SOURCE OF FINANCE
The businesss reputation
Is it reliable and popular?
This may allow managers to persuade suppliers to offer increased trade
credit
Will assist in negotiating loans or persuading shareholders to purchase
shares
Its legal structure
Will play a role in deciding appropriateness of sources of finance
Should they use share capital as a source to fund start-ups or expansions?
CHOOSING AN APPROPRIATE
SOURCE OF FINANCE
Business environment
If sales in a market are growing, the business may be more able to
finance loan repayments
On the other hand if interest rates are high, making loan capital a
relatively expensive source a finance, the business may seek alternative
sources
CASE STUDY: VENTURE
CAPITAL SCARCE IN THE USA
1. Explain the circumstances in which a company might choose to use
venture capital as its primary source of finance.
A small or medium-sized business is less likely to have a wide range of
options. Many banks are currently unwilling to lend to smaller businesses
VCs often provide support and guidance and can be extremely helpful
2. Discuss the other factors that may have led to the decline in the
amount of money lent by venture capitalists in the third quarter of
2012.
The recession may have reduced opportunities VCs saw worthwhile; fewer
businesses would have been started