Unit 2: Sources of Finance

I. Orientation — The Financing Framework

Sources of finance are the channels through which a company obtains funds for investment, operations, and growth. The governing principle is to match each financing source to the amount required, duration of need, risk of the project, expected cash flows, and desired balance between ownership and borrowing.

• Defining properties:
  • Maturity: Finance may be short-term, normally repayable within one year, or long-term, generally available for more than one year.
  • Ownership: Equity represents an ownership interest, whereas debt creates a contractual obligation to lenders.
  • Return: Shareholders receive dividends and capital gains; lenders receive interest and repayment of principal.
  • Risk: Debt increases financial risk because interest and principal are contractual obligations. Equity dividends are generally discretionary.
  • Control: Issuing voting shares can dilute existing owners’ control; borrowing normally does not confer voting rights.
  • Security: Debt may be secured against specific assets or supported only by the borrower’s general creditworthiness.
  • Matching principle: Long-lived assets should generally be financed with long-term capital, while temporary working-capital needs may use short-term finance.
• Core financing requirement:

Financing requirement = Investment expenditure + Working-capital need
                        − Internally available funds

• Investment expenditure: Spending on assets such as buildings, machinery, or acquisitions.
• Working-capital need: Funds tied up in inventories and receivables, net of operating liabilities.
• Internally available funds: Retained earnings and cash generated from operations that can be reinvested.

II. Finance by Maturity — Matching Funding to the Period of Need

A. Long-term sources of finance

Long-term sources provide capital for permanent or multi-year requirements such as fixed assets, expansion, acquisitions, and a stable level of working capital.

• Ordinary share capital: A company issues ownership interests with no normal repayment date; investors supply permanent capital in exchange for voting and residual financial rights.
• Preference share capital: Investors usually receive a fixed or predetermined dividend and priority over ordinary shareholders, although their voting rights are commonly restricted.
• Debentures and bonds: The company borrows for a specified or indefinite period and normally pays contractual interest; the debt may be secured or unsecured.
• Term loans: Banks or other institutions lend a fixed amount repayable through instalments or a final payment over several years.
  • Example: A five-year loan of $500,000 may require annual interest plus scheduled principal repayments.
• Retained earnings: Profits kept within the business provide internally generated long-term finance.
  • Concrete effect: If profit after tax is $200,000 and dividends are $80,000, retained earnings increase by $120,000.
• Leasing: The business obtains the right to use an asset in return for periodic payments, reducing the immediate cash required to acquire it.
• Advantages:
  • Funding stability: Long maturities reduce the need for frequent refinancing.
  • Asset matching: A factory expected to operate for 20 years is more appropriately financed by permanent capital or multi-year debt than by a three-month facility.
  • Large capacity: Public share or bond issues can raise substantial sums.
• Limitations:
  • Issue costs: Legal, advisory, underwriting, and regulatory expenses may be significant.
  • Long commitment: Interest, lease payments, or shareholder expectations can persist even when conditions deteriorate.
  • Possible dilution: New ordinary shares can reduce existing shareholders’ ownership percentages and voting influence.

B. Short-term sources of finance

Short-term sources fund operating-cycle needs and temporary cash deficits, usually for periods of up to one year.

• Trade credit: Suppliers allow goods or services to be purchased now and paid for later, such as under “30-day” terms.
  • Cost implication: Forgoing an early-payment discount can make apparently free credit expensive.
• Bank overdraft: A bank permits the company’s current account to fall below zero up to an agreed limit; interest is charged on the amount used.
• Short-term bank loan: A fixed sum is borrowed for a defined period, commonly to meet seasonal inventory or cash-flow requirements.
• Commercial paper: Large, creditworthy companies issue unsecured short-term notes directly to investors, normally at a discount to face value.
• Factoring: Receivables are sold to a factor, which may also administer collections and bear some or all customer default risk.
• Invoice discounting: Receivables support an advance while the company usually retains responsibility for its sales ledger and customer collection.
• Accrued expenses: Wages, taxes, or other costs recognized before payment temporarily finance operations, although deliberate late payment can cause penalties and reputational damage.
• Advantages:
  • Flexibility: An overdraft can expand or contract with daily cash needs.
  • Speed: Existing facilities are often quicker to access than issuing long-term securities.
  • Potentially lower explicit cost: Interest applies for a shorter period and, for overdrafts, generally only to funds drawn.
• Limitations:
  • Refinancing risk: A lender may decline to renew a facility when it matures.
  • Interest-rate exposure: Short-term rates may change quickly, increasing finance costs.
  • Liquidity pressure: Financing a ten-year asset with a three-month loan creates repeated repayment and renewal obligations.

III. Share Capital — Ownership-Based Finance

A. Ordinary shares

Ordinary shares represent the basic ownership capital of a company and give their holders a residual claim after all prior obligations have been met.

• Voting rights: Holders commonly vote on matters such as electing directors, often on the basis of one vote per share.
• Dividend rights: Dividends are normally paid only when declared and depend on profitability, cash availability, and corporate law; they are not contractual interest payments.
• Residual claim: On liquidation, ordinary shareholders receive value only after employees, tax authorities, secured and unsecured creditors, and preference shareholders have satisfied claims.
• Capital return: Investors may gain if the market price rises, but they also bear losses if the price falls.
• Permanent finance: Ordinary shares generally have no maturity date and are not routinely redeemed by the company.
• Company advantages:
  • No compulsory dividend: A company may retain cash during weak trading periods.
  • Loss absorption: Equity bears business losses before creditors, strengthening the protection available to lenders.
  • Borrowing capacity: A larger equity base may support future debt finance.
• Company disadvantages:
  • Control dilution: An owner holding 600 of 1,000 shares controls 60%; issuing another 1,000 shares to others reduces that interest to 30% unless the owner subscribes.
  • Potentially high required return: Shareholders demand compensation for taking residual risk.
  • Issue complexity: Public offerings may require extensive disclosure, underwriting, and regulatory compliance.
• Investor return:

Shareholder return = (D₁ + P₁ − P₀) / P₀

• D₁: Dividend received during the period.
• P₁: Share price at the end of the period.
• P₀: Share price at the beginning of the period.

B. Preference shares

Preference shares are ownership securities that normally rank ahead of ordinary shares for dividends and repayment of capital but behind creditors.

• Preferential dividend: The dividend is often stated as a fixed amount or percentage of nominal value.
  • Example: An 8% preference share with a $100 nominal value normally carries an $8 annual dividend.
• Priority: Preference dividends are paid before ordinary dividends, and preference capital ranks ahead of ordinary capital in liquidation.
• Voting position: Holders commonly have limited voting rights, although rights may arise when dividends are in arrears or specified decisions affect their class.
• Cumulative shares: Unpaid dividends accumulate as arrears and must normally be cleared before ordinary dividends can be distributed.
• Non-cumulative shares: A dividend omitted for a particular period does not accumulate for future payment.
• Participating shares: Holders may receive an additional return after a stated ordinary dividend or profit threshold is reached.
• Convertible shares: The instrument may be exchanged for ordinary shares under predetermined terms.
• Redeemable shares: The company repays the capital on a specified date or under stated conditions, subject to applicable corporate law.
• Advantages:
  • Control preservation: Restricted voting rights may limit dilution of ordinary shareholders’ control.
  • Financial flexibility: Preference dividends are generally less legally binding than debt interest.
• Limitations:
  • Priority burden: Ordinary dividends cannot normally be paid until preference entitlements are met.
  • Tax treatment: Preference dividends are usually distributions from after-tax profit, unlike debt interest where tax rules permit a deduction.

IV. Debt Instruments — Contractual Long-Term Borrowing

A. Redeemable and irredeemable debentures

Debentures are long-term debt instruments under which a company promises interest and repayment according to the issue terms; terminology and security arrangements vary by jurisdiction.

1. Redeemable debentures:
   • Maturity: Principal is repaid on a specified date or through scheduled redemptions.
   • Cash-flow obligation: A $1,000, 6% debenture redeemable in five years normally pays $60 annual interest and $1,000 at maturity.
   • Investor valuation:

P = Σ[C / (1 + k)ᵗ] + F / (1 + k)ⁿ

• P: Current debenture value.
• C: Periodic interest payment.
• k: Investor’s required return per period.
• t: Each payment period.
• F: Redemption or face value.
• n: Number of periods to maturity.
• Company implication: The borrower must plan for refinancing or accumulate cash for redemption.

2. Irredeemable debentures:
   • No fixed repayment date: Principal remains outstanding indefinitely unless contractual provisions permit repurchase or repayment.
   • Perpetual interest: The holder receives a continuing fixed interest stream.
   • Valuation:

P = C / k

• P: Value of the irredeemable debenture.
• C: Annual interest payment.
• k: Required annual return.
• Risk implication: Value is highly sensitive to market interest rates because there is no near maturity date pulling price toward face value.

• Shared characteristics:
  • Priority: Debenture holders rank before shareholders for interest and liquidation claims.
  • Security and covenants: Terms may include charges over assets and restrictions on additional borrowing, dividends, or asset disposals.
  • Default exposure: Failure to pay contractual interest or principal can trigger enforcement action.

V. Capital Structure — Choosing Between Financing Claims

A. Debt versus equity

Debt versus equity concerns the trade-off between the lower, contractual cost of borrowing and the greater flexibility and loss-absorbing capacity of ownership finance.

1. Debt:

   • Return: Interest is contractual and commonly tax-deductible where tax law permits.
   • Control: Lenders do not normally vote, so ownership control is preserved.
   • Risk: Interest and principal must be paid despite low profits; excessive borrowing can cause financial distress.
   • Leverage effect: Debt can increase returns to shareholders when operating returns exceed borrowing costs, but it magnifies losses when they do not.

2. Equity:

   • Return: Dividends are generally discretionary, while shareholders participate in growth through dividends and capital gains.
   • Control: New voting shares may dilute existing owners’ influence.
   • Risk: There is no routine principal repayment, reducing insolvency pressure.
   • Cost: Investors usually require a higher return because they rank last and bear residual business risk.

• Decision factors:
  • Cash-flow stability: Predictable operating cash flows can support more debt than volatile cash flows.
  • Gearing: Higher debt relative to equity increases fixed financing commitments.
  • Security available: Tangible assets can support secured borrowing.
  • Financial flexibility: Maintaining unused borrowing capacity helps a company withstand shocks or fund opportunities.
  • Optimal balance: The preferred mix aims to minimize the weighted average cost of capital without creating unacceptable distress, agency, refinancing, or control risk.