Limitation in Raising External Sources of Finance Free Sample

Question: Discuss about the Source of Finance. Answer: Introduction Organization is consisted of several set of procedures in which various functions are performed to achieve certain goals and objectives. Capital is the amount of money engaged in the business functioning for smooth running of its value chain activities. In todays world each and every business needs money. Purpose External sources of finance means capital arranged from outside of business unlike retained earnings which are generated internally from the activity of business as have or being done for the purpose to earn profit from business (Brigham Ehrhardt, 2016). External source of finance are those finance where a businessmen arrange the finance by following modes e.g. equity share, bank loan, preferred stock ,debenture, term loan ,venture capital, leasing, hire purchase, trade credit, bank overdraft, and factoring which are used at the time of need of capital to start, run or grow businesses in significant manner (Arora, 2013). Scope It can either be raised through internal sources of finance or external sources of finance. Internal sources of finance refers to the process in which finance is raised from the business itself whereas, external sources of finance mean those sources of finance which are outside the business i.e. where funds are raised outside the business. Methodology There are several different sources of external finance for public listed companies which could be used for raising funds from the market. Some of the external sources are equity capital, debentures, venture capital, term loans, leasing, hire purchase, bank overdraft and factoring. Ideally, these types of funding are useful for the organizations having strong brand image. Limitation The main limitation in raising external sources of finance is limited number of options for organization for raising finance for company. All the data has been collected from primary and secondary sources which could be misrepresentative in calculating cost of capital and total issued capital. External source of finance for listed company having effective track record in market Issue of capital (Shares and debentures) Company is derived and owned by two separate persons. Directors are the persons who drive the company and shareholders are the real owners. In this kind of External source of finance, companies issue its equity share capital through (IPO/FPO) public issue in stock market (Hargovan Harris, 2011). This kind of finance is useful only for big Companies which are listed in Stock Exchanges. It becomes cumbersome process which put obligation on listed companies to comply with different legal formalities which are governed by lot of legislation (Beck, 2016). Advantages: These are the persons who have direct control over the management of the firm and it becomes dangerous for company if one person buy more than 51% share in market. They are entitled to dividend. Sharing of ownership right is the main characteristic of this finance. Therefore, right hold by shareholders is diluted to some extent (Fonseca, 2010). Disadvantages: Equity share holders bear the highest degree of risk of the company. Dividend is given only in case of profits after paying interest on debentures and tax(Hanssens, Deloof and Vanacker, 2015). In comparison to other sources of finance it carries higher floatation expenses of brokerage and underwriting commission. It is costly compare to debt finances because the return to shareholder will be given in form of bonus share or dividend which is not subject to TDS (Fonseca, A. (2010) Issues of Debenture It is a kind of a debt documents that are not secured by physical assistance. These are most common form of long term loans. They are redeemed on a fixed date and pay a fixed rate of interest. Debts is consider to be the cheaper mode of finance compared to equity. This is another source of finance which prefer by companies over the equity. In this case company has to pay interest to its debenture holders and it is tax deductible. It is presented to public and there for necessary legislation need to be comply with and the rest of the process off issuing is quite similar to shares (Zattoni Judge, 2012). Advantages: Issuing of debentures does not dilute the control of the existing shareholders of the company over the business. Also they are entitled to interest so profit does not get diluted. A unique characteristic of this finance is that it does not share ownership or share control like preference or equity share does. Disadvantages: Interest payment to debenture holder is an obligation. It also raises the leverage of the business (Turner, 2014). Issues of preferences shares These types of shares are ideally issued by listed company. In terms of payment of dividend and share capital at time of liquidation of company, holders of preference shares are given priority over equity share capital. Once the dividend has been declare in general meeting of company it has to be paid and cannot be ignored. There is another category off preferred share collected cumulative preference share where share has its dividend return accumulated till it is not paid. Advantages- Holders of preference shares are given priority over equity share capital. Disadvantage- They are not entitled for voting in general meeting. Borrowing for start up and growing business (In case, when company introduce new product or diversified business in market (Routledge, Sargeant, Jay 2014). Use of venture capital It is amount that is provided by venture capitalist to SME and early stage emerging firms that have high growth potential. These funds are provided by incubators who are ready to take high risk for high amount of profit (Platon, Frone Constantinescu, 2014). In this External source of finance Investors are the different set off people who invest in newly form company where probabilities of business growing high is either 100% or 0%. It is a new idea in the market on the basis of which company starts is business. The people who invest money in this business are known as capitalist they usually invest in a company at preliminary stage after applying accurate analysis (Barton and Wiseman, 2014). For instance, if a company takes investment of $ 20, 00,000 at a rate of 8% and compensating requirement is that company would have to pay at least 50% return to its venture capitalist if projects get successful. It provides that effective rate of borrowing amount would be 20, 00,000*50%= 10, 00,000 (Black Gilson,1998). Advantages: New innovative projects find a source of finance for them. In addition to this firms also provide information, resources, technical assistance to the emerging firms (Webley Werner, 2008). Disadvantages: It is uncertain in nature and benefits can be realized in long run only. Bank loan and advances External source of finance is obtained by listed companies as per their different need of finance from bank or financial institution. It is quite similar to debenture except issuing cost because common public is not involved in this process. Bank or financial institution do analysis of companys financial statement and plans to evaluate the debt services capacity of the company. Mortgage loan can also be provided by bank or financial institution by securing some assets of company. In addition to this, there is another loan which is called term loan. It is a monetary loan that is paid again in regular payments in determined time period. It usually ranges from one to ten years. Ideally a bank provides this source of finance as facilities to its clients. (Brigham and Ehrhardt, 2016). Advantages: Interest paid is tax deductible. There is no dilution of control in management since lenders has no right to vote. Interest paid is tax deductible. No dilution of control over the management since lenders has no right to vote (Needles and Crosson, 2007). Disadvantages: Firm is lawfully obliged to pay interest and main principle amount. It raises the financial leverage of the firm which in turn raises the cost of equitym (Frank, Shen, 2016). Company is legally obliged to pay interest amount and charged it against its profit. It also increases the financial leverage of the firm which in turn raises the cost of equity (Roth, 2017). Factoring of debtors Factoring is a financial business in which organizations sells its account receivable to another party at discount amount and in turn business gets a cash advance. In this source of finance Companies sells its debtors at discount to the buyers. These buyers are known as factors that collect the cash from debtors on behalf of company and charges commission for the consideration. There are two kind of factoring such as resource factoring and non resources factoring. Resource Factoring bears the bad debts of company while non resources do not bear the bad debts of business (Cholakova Clarysse, 2015). Advantages: It is lot more time saving in comparison to other sources. Instant cash can be used for growth prospects. Disadvantages: Once we accept cash for our receivables we give up a measure of control. Also factoring comes at higher price than loans (Qu, 2016). easing Hire Purchase In this External source of finance, there is an option in which company could enter into leasing contract with supplier of goods over payment of their debts to company. It helps businesses to block fewer amounts in its value chain activities. Generally, hire purchases option is provided by big suppliers and gives option to buy assets at the end of its terms (Davis Davis, 2011). Advantages- It helps in reduction of amount blocked in its value chain activities Disadvantage- It is costly process and increase total cost of production of company. Other sources of finance Trade credit is the facility generated by mutual agreement between creditors and company. It is given by creditors to business which allows it to make delay in its payment by some period. The POC (Period of credit) will depend on the terms and condition between business and creditors (Pinto Reis, 2017). Advantages- The period of credit will depend on the terms and condition between business and creditors. Disadvantages- sometime it becomes cumbersome process to take trade credit loan. There are several considerations which are to be kept in mind by organizations before raising funds from the market. Company would consider lock in period of making repayment of the money taken from the market. Financial cost and other interest amount which would be required. Risk associated with the choosing methods Cost of capital Attached liabilities with the options Selection of best financial course of action for raising finance for the company There is no set of rules and regulation for selecting source of finance for raising capital for the organization. However, endeavor should be made towards keeping low cost of capital and longer lock in period. It could be justified with the practical example that if company X is having requirement of $ 10, 00,000 amount then management department would use mix source of finance for raising capital for the organization. Company should use issue of equity shares to people for generating $ 5,00,000 and $ 5,00,000 could be used by other sources such as issue of debentures, factoring and banks loans. Weighted average cost of capital would play important role in assigning the accurate weight to all the capital parts of company. It helps company to reduce its financial leverage and risk associated with capital of organization. Critical evaluation by using WACC in raising long term finance This Critical evaluation by using WACC in raising long term finance could be determined by using an example. This will provide how a company could reduce its cost of overall capital by using different source of finance for raising capital for the company. If company X takes loan of $ 10, 00,000 from different banks such as $ 5, 00,000 loan from Wes bank $ 2, 00,000 loan from Barclays $ 3, 00,000 loan from American express Weighted average cost of capital would be computed with a view to compute required rate of return for the company. Lender Balance Rate Banks name Wes bank $ 5, 00,000 5% Banks name Barclays $ 2, 00,000 6% Banks name American express $ 3, 00,000 7% Weighted average cost of capital would be computed as below Portion of loan taken * Rate assigned to each loan by banks (5, 00,000/10, 00,000)*.20+ (3, 00,000/10, 00,000) *30+ (2, 00,000/10, 00,000)*.50 5%*.20+ 6%*.30+ 7%*.5 1+ 1.8+1.35 4.15 % Company has 4.15% minimum rate of return below which would not accept any project for its business functioning (Rao, 2011) Capital structure of three identical firms Capital structure- This is comprised with all the sources of capital which are used by company. It is analyzed that optimum level of capital structure helps organization to reduce the overall cost of capital for the business. For instance, If company is having requirement of $ 5, 00,000 then they could go for several sources of finance e.g. issues of shares, Issue of debts and other sources (venture capital fund, Bank loan and securitization of assets). These three companies require $ 50, 00,000 for financing their new projects. Particular Company A Company B Company C Cost of capital Capital required $ 50, 00,000 $ 50, 00,000 $ 50, 00,000 $ 50, 00,000 Issues of debts 50%= 25,00,000 60%= 30,00,000 70%= 35,00,000 10% Issues of equity 40%= 20,00,000 30%= 15,00,000 20%= 10,00,000 15% Other sources( Venture capital, factoring and other ways 10%= 5,00,000 10%= 5,00,000 10%= 5,00,000 10% It is analyzed that optimum level of capital structure helps organization to reduce the overall cost of capital for the business. Total cost of capital for Company A= 6, 00,000 25,00,00*10%= 2,50,000 20,00,000*15%= 3,00,000 5,00,000*10%= 50,00,000 Total cost of capital for Company B= $ 5, 75,000 30,00,00*10%= 3,00,000 15,00,000*15%= 2,25,000 5,00,000*10%= 50,000 Total cost of capital for Company C= $ 10, 00,000 35,00,000*10%= 3,50,000 10,00,000*15%= 1,50,000 5,00,000*10%= 5,00,000 Company B has least cost of capital. Therefore, it could be said that company B has optimum capital structure. Weighted average cost of capital Weighted average cost of capital provides rate at which company is expected to pay to all its security holders to finance its assets. It is also called as total Average cost of capital of organization. It is the least return that a company should earn on assets in order to satisfy its creditors, owners, or the other capital providers (Needles Crosson, 2007). It could be defined with the help of example that if company X proposes to raise capital by issuing of debts and loans from banks then the level of financial leverage could be gauged by using WACC. It provides to what extent company could entertain financial risk in its business. This financial risk is used by company to determine how company could reduce its cost of capital for overall business functioning (Aggarwal, et al. 2014). It is observed that company raises money from number of sources like shares, debt, options and governmental subsidies. There are different scriptures which provide several sources of finance which are considered by organizations to generate several returns (Brigham Ehrhardt, 2016).Under this, relative weights are assigned to each component in capital structure. The more critical the capital structure then it would more laborious is to calculate WACC. WACC is used by companies to observe if the asset projects available to them are meaningful to undertake (Minsky, 2015). There is following formula which could be used to calculate WACC of Company (Nirajini Priya, 2013). WACC = E/V*Re + D/V*Rd (1-Tc) Where Re = cost of equity Rd = cost of debt E = market value of the firms equity D = market value of the firms debt V = E+D (total value of the firms equity and debt) E/V = percentage of financing that is equity D/V = Percentage of financing that is debt Tc = corporate tax rate (Minnis and Sutherland, 2017). WACC is used as quantify tool to make a decision whether to spend. The WACC reflect the least amount rate of return at which a company produces value for the person who invests money. It serves as a reality test for the investors (Jensen, 2005). It could be inferred that WACC is altered by making dilution in the capital structure. It is assumed that cost of debt is not equal to cost of equity. The cost of equity is higher than cost of debt. So if there is increase in equity financing WACC will also increase. Equity finance has no collision on profitability but equity financing can make changes in ownership of existing shareholders because net income is divided among large number of shares. Equity financing leads to positive item in CFS and increase in common stock on the balance sheet (Jansen, 2016). If a firm raises debt money then there is a constructive item in financing section of CFS as well as add to in liabilities on the balance sheet. Debt financing includes principal which h as to be paid to lenders. Debt does not dilute ownership. However, interest payment on debt reduces net income as well as cash flow. Reduction in net income leads to tax benefit. Increase in debt causes rise in leverage ratio. In the event when company goes in winding up debt holders are senior to equity holder (Heal Palepu, 2012). Company should try to make a proper ratio between the various sources of finance so as to make a viable decision for the business. Another example could be used for the better understanding of this WACC. Suppose organizations is having 15% return from its business functioning and there are two options available for the company. It could either go for raising funds from issues of shares and dividend amount would be 15% on capital investment or issues of debts at the interest amount at 10%. In this case as per WACC, company should go for raising funds from issues of debentures in market (Knack Xu, 2017). Therefore, it could be inferred that WACC helps org anizations to choose right amount of long term sources of funds which reduce cost of capital of organization (Hirschey, 2008). Financial leverage is used to determine the companys sustainability position and its capability to pay off its short term and long term debts. WACC is used to measure the weight assigned to each capital component in organization. This provides how company could reduce its overall cost of capital. In addition to this, WACC is also used to gauge the minimum level of return that company needs to earn from its business functioning to create value. For instance, Company X has WACC of 15% then it is the minimum required return that company should earn from its business functioning. Otherwise it would result into destruction of capital value of company (Hargovan Harris, 2011). It could be defined with WACC example. For instance, banks and financial institutions who lend money to company X requires 12% interest rate and shareholders of the company has 15% dividend rate expectation. Now calculating WACC it is observed that both parts in company are weighted 50% each. Therefore, as per WACC calculation required rate of return to company from its business functioning would be 50%* 15%+ 50%* 12%= 13.5. 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