3.1 Sources of Finance Key Outcomes: • Understand internal and external finance • Analyse the different sources of long-term, medium-term and short-term finance • Understand the role played by the main financial institutions • Evaluate the advantages and disadvantages of each form of finance for a given situation PREWATCH: • http://www.youtube.com/watch?feature=play er_embedded&v=qEiv2YOxnyc (15mins) • Extension: http://www.youtube.com/watch?v=mKru3F5v dyY (10 mins) Why may business finance be required? • Setting up a business will require start-up capital to purchase essential capital equipment. • Businesses need to finance their working capital - the day-to-day finance needed to pay bills and expenses and build up stocks. • Business expansion needs finance to increase the capital assets held by the firm, and, usually, higher working capital needs. • Expansion can be achieved by acquiring other businesses. Finance is needed to buy out the owners of the other firm. • Special situations (e.g. a major customer cannot pay for an order, an economic crisis) may require immediate finance to tide the business over. • Finance is often used to pay for research and development into new products or to invest in new marketing strategies (e.g. an overseas expansion). Internal finance • Internal money raised from the businesses own assets or from profits left in the business (retained profits) External finance • External money raised from sources outside the business What is working capital? http://www.investopedia.com/terms/w/workingcapital.asp What is capital expenditure? http://www.investopedia.com/terms/c/capitalexpenditure.asp Equity vs Debt? http://www.youtube.com/watch?v=yQtUyBrRBx4 (14mins) What are shares (stocks)? http://www.investopedia.com/terms/s/shares.asp What is a bond? http://www.investopedia.com/terms/b/bond.asp What’s a Debenture? http://www.investopedia.com/terms/d/debenture.asp What’s an IPO? http://www.investopedia.com/terms/i/ipo.asp What’s a divined? http://www.investopedia.com/terms/d/dividend.asp • * The IB Business and Management course does not require you to differentiate between bonds and debentures. However, the question regularly comes up in the classroom. The essential difference between a bond and a debenture is that a debenture is secured against the assets of a company (if the company goes bankrupt, investors will be first in line to get their money back), whereas a bond is unsecured and therefore has an increased element of risk. Sources of internal finance: • Retained profits • Sales of assets • Reduction in working capital Sources of External finance: Sources of LONG TERM external finance: • Share issue • Debentures • Long-term loan • Grants Sources of MEDIUM TERM external finance: • Leasing • Hire purchase • Medium-term loan Sources of SHORT TERM external finance: • Bank overdraft • Bank loan • Creditors • Trade credit • Debt Factor (What’s debt factoring? http://www.youtube.com/watch?v=xQQTNZ9Ld1U) Advantages Advantages of debt finance: • As no shares are sold, the ownership of the company does not change and is not 'diluted' by the issue of additional shares. • Loans will be repaid eventually, so there is no permanent increase in the liabilities of the business. • Lenders have no voting rights therefore there is no loss of control of the company. • Interest charges are an expense and are thus tax deductible (reduce the total company tax paid by the business). Advantages of equity finance: • It never has to be repaid. • Dividends do not have to be paid every year. In contrast, interest must be paid when demanded by the lender. • Much larger amounts of finance can possibly be raised than through debt financing. Factors influencing finance choice: 1. Use to which finance is to be put - which affects the time period for which finance is required: • It is very risky to borrow long-term finance to pay for short-term needs. Businesses should match the sources of finance to the requirement. • Permanent capital may be needed for long-term business expansion. • Short-term finance would be a dvisable to finance a short-term need to increase stocks or pay creditors. 2. Cost: • Obtaining finance is never 'free' - even internal finance may have an opportunity cost. • Loans may become very expensive during a period of rising interest rates. • A stock exchange flotation can cost millions of dollars in fees and promotion of the shares for sale. 3. Amount required: • Share issues and sales and debentures, because of their administration and other costs, would generally only be used for large capital sums. • Small bank loans or reducing debtors' payment period could be used to raise small sums. 4. Legal structure and desire to retain control: • Share issues can only be used by limited companies - and only public limited companies can sell shares directly to the public. Doing this runs the risk of current owners losing some control - except if a rights issue was used. • If the owners want to retain control of the business at all costs, then a sale of shares may be unwise. 5. Size of existing borrowing: • This is a key issue - the higher the existing debts of a business (compared to its size), the greater the risk of lending more. Banks and other lenders will become anxious about lending more finance. • This concept is referred to as gearing and is fully covered in 3.6 Ratio Analysis. 6. Flexibility: • When a firm has a variable need for finance - for example, it has a seasonable pattern of sales and cash receipts - a flexible form of finance is better than a long-term and inflexible source. Factors affecting the choice of funding The amount required The cost of the money Advice available Choosing a funding method Loss of control The risk involved The length of time for which the money is needed 11 Funding in the real world The airline ‘Go’ was sold by British Airways in 2001 for £110 million. 43% of the shares were held by 3i – a venture capital company. In 2002, Easyjet bought Go for £374 million – and financed the purchase by offering new shares to existing shareholders. Q. How much money did 3i make on the deal? 12 Which would you choose? If you had to find the finance for: • A fleet of new cars for sales staff? • Short-term finance to pay a large bill one month? • Long-term finance for a small, thriving IT firm? • A company setting up in a deprived area? • A plc which wants to expand abroad? 13 Were you right? Answers Fleet of cars = hiring/leasing Short-term to pay a bill = bank overdraft Long-term for IT firm = venture capital Company in deprived area = government grant Plc expanding abroad = selling shares 14 Exam Tips! • Do not assume that a profitable business is cash rich - and that it can use all of its profits as a source of finance for future projects. In practice, profits are often 'tied up' in money owed to the business by debtors or have been used to finance increased stocks or replace equipment. • Do not make the mistake of suggesting that selling shares is a form of internal finance for companies. Although the shareholders own the business, the company is a separate legal entity and, therefore, the shareholders are 'outside' of it. • When answering case study exam questions, you should analyse what type of legal structure the business has and what sources of finance are available to it. • You should be able to recommend appropriate sources of finance for businesses needing capital for different reasons. ACTIVITY • Download the assessment tasks 3.1 from the wiki.