short term & long term finances

7/30/2019 short term & long term finances

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Introduction

1. Business concern needs finance to meet their requirements in the economic world. Anykind of business activity depends on the finance. Hence, it is called as lifeblood of businessorganization. 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 economicactivities and very particular to earning profit through any venture or activities. The entirebusiness activities are directly related with making profit. (According to the economics conceptof factors of production, rent given to landlord, wage given to labour, interest given to capitaland profit given to shareholders or proprietors), a business concern needs finance to meet all therequirements. Hence finance may be called as capital, investment, fund etc., but each term ishaving different meanings and unique characters. Increasing the profit is the main aim of anykind of economic activity. Finance can be needed for a variety of different reasons, which willhave an effect on what the most appropriate sources of finance will be. Finance could be neededfor:

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 financialservice and financial instruments. Finance also is referred as the provision of money at the timewhen it is needed. Finance function is the procurement of funds and their effective utilization inbusiness concerns.

3. The concept of finance includes capital, funds, money, and amount. But each word ishaving unique meaning. Studying and understanding the concept of finance become an importantpart of the business concern.

Definition of Finance

4. According to Khan and Jain, Finance is the art and science of managing money.

5. According to Oxford dictionary, the word finance connotes management of money.

6. Websters Ninth New Collegiate Dictionary defines finance as the Science on study ofthe management of funds and the management of fund as the system that includes thecirculation of money, the granting of credit, the making of investments, and the provision ofbanking facilities.

Definition of Business Finance


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7. According to the Wheeler, Business finance is that business activity which concernswith the acquisition and conversation of capital funds in meeting financial needs and overallobjectives of a business enterprise.

8. According to the Guthumann and Dougall, Business finance can broadly be definedas the activity concerned with planning, raising, controlling, administering of the funds used inthe 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 nonfinancialfields 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 thebusiness 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 thefinancial problems of corporate enterprises. These problems include the financial aspects of thepromotion of new enterprises and their administration during early development, the accountingproblems connected with the distinction between capital and income, the administrativequestions created by growth and expansion, and finally, the financial adjustments required forthe 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 thefinancial 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 whichare for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etcare considered as long term financial needs. Funds required to finance permanent or hard coreworking capital should also be procured for long term sources.

(b) Medium Term Financial Needs. Such requirements refer to those funds which arerequired for a period exceeding one year but not exceeding 5 years. For example, if a companyresorts to extensive publicity and advertisement campaign then such expenses may be written offover a period of 3-5 years. These are called defferd revenue expenses and funds required forthem are classified in the category of medium term financial needs.

(c) Short Term Financial Needs. Such type of financial needs arise to finance incurrent assets such as stock, debtors, cash etc. Investment in these assets is known as meeting ofworking capital requirements of the concern. The main characteristic of short term financialneeds is that they arise for a short period of time not exceeding the accounting period i.e oneyear.


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Types of Finances

13. The need for finance may be for long-term, medium-term or for short-term. Financialrequirements 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 likeissue of shares and debentures provide money for a longer period. These are therefore, known assources 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 ofshort-term finance. In this lesson you will study about the various sources of short-term financeand 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 lessthan 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. Forexample raw materials must be purchased at regular intervals, workers must be paid wagesregularly, water and power charges have to be paid regularly. Thus there is a continuousnecessity of liquid cash to be available for meeting these expenses. For financing suchrequirements 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 servesfollowing purposes

(a) It facilitates the smooth running of business operations by meeting day to day financialrequirements.

(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 acertain period and collection of money from debtors takes time. During this time gap, productioncontinues and money will be needed to finance various operations of thebusiness.

(d) Short-term finance becomes more essential when it is necessary to increase the volume ofproduction at a short notice.

Sources of Short-term Finance


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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 ofsales. There are a number of sources of short-term finance which are listed below:

(a) Trade Credit

(b) Bank Credit(c) Customers Advances(d) Installment Credit(e) Loans from Co-operative Banks

Trade Credit

17. Trade credit refers to credit granted to manufactures and traders by thesuppliers of rawmaterial, finished goods, components, etc. Usuallybusiness enterprises buy supplies on a 30 to90 days credit. This means that the goods are delivered but payments are not made until theexpiryof 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 smallbusiness based between Nottingham and Lincoln. The business makes high quality kitchenfurniture. The vast majority of the work done by the business is strictly to order and made to suitthe specific requirements of the customer. Hill Farm use wood - lots of it! When they receive adelivery from their supplier they do not pay straight away. They will receive a 28 day periodbefore having to settle the bill. For many small firms, this effectively means they are gettingsome 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 fromtheir supplier for 28 days - interest free. This gives the business the time to be able to managetheir finances and balance their cash flows more effectively. If a business did not pay the debtafter the 28 days has past then there might be a penalty to pay. The supplier might charge a fee orstart charging interest or even take the business to court to get its money back. Non payment ofdebts like this can cause businesses - especially small businesses - real problems. If they are notreceiving money for the goods they have supplied they cannot pay their own debts. This is quitea popular source of finance

Bank Credit

18. Commercial banks grant short-term finance to business firms which is known as bankcredit. When bank credit is granted, the borrower gets aright to draw the amount of credit at onetime or in installments as and when needed. Bank credit may be granted by way of loans, cashcredit, overdraft and discounted bills.

(a) Loans. When a certain amount is advanced by a bank repayable after aspecifiedperiod, it is known as bank loan. Such advance is credited to a separate loan account and theborrower 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 towithdraw money upto a specified limit. This limit is known as cash credit limit. Initially this


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limit is granted for one year. This limit can beextended after review for another year. However,if the borrowerstill desires to continue the limit, it must be renewed after threeyears. Rate ofinterest varies depending upon the amount of limit.Banks ask for collateral security for the grantof cash credit. In this arrangement, the borrower can draw, repay and again draw the amountwithin 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 thedeposits (money put into the account) and withdrawals (money taken out). Most banks know thatbusinesses do not always receive money from sales straight away. If you run a sandwich bar in alocal trading estate then you might get money straight away when you sell your sandwiches. Ifyou are a business selling electrical equipment to an electrical retailer then you may not get paidstraight away when you deliver your goods.When differences occur in the money a businessreceives 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 moneyflowing 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 enoughmoney in its account to pay the bill. It might know that it is due to receive Rs 350000 froma customer on the 10th December but in the meantime it has a cash flow problem. This is when itis appropriate to arrange an overdraft with a bank. An overdraft is an agreement with a bank toallow the business to spend money it does not have - it is a form of a loan therefore. In ourexample, the business might arrange for an overdraft facility of Rs 500000 with its bank. It cannow 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 returnedto the business and if this happens a charge is made to the business. Not only do bouncedcheques cost the business money in bank charges but the relationships with its suppliers can bedamaged. Some suppliers might think twice before supplying the business with any more stockin such circumstances!

Arranging an overdraft avoids this problem. The business will get charged interest on the amountthey have loaned. In our example, the overdraft facility is Rs 500000. If the business only usesRs 150000 of that limit, they only pay interest on the Rs 150000, not the whole Rs 500000. Thisis a key difference between an overdraft and a loan.

Overdraft facilities do have their disadvantages. The interest rate on an overdraft can be quitehigh, especially for small firms where the risk to the bank that they might not get their moneyback is greater. In addition, the business is not allowed to exceed their overdraft limit. If they dothe bank might refuse to pay cheques to creditors (people who are owed money) and may hit thebusiness with a hefty charge for exceeding the limit. Overdraft facilities can be re-negotiated butif this is tried too many times, it may be a signal to the bank that a business has not got controlover its finances.


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(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 fordiscounting, banks credit the amount tocustomers account after deducting discount. The amountof discountis 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 cashimmediately. He does not have to wait for the payment until the expiry of credit period stated onthe bill.

(ii) No extra security is to be offered. Banks generally do not ask for any other securitywhile making payment against the bill discounted. However, if a customer is interested, banksalso grant him limit for discounting of bills. This limit is known as limit against discountedbills. 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 discountedbill 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 thedrawee does not pay or refuses to pay, the drawer or the person who got payment afterdiscounting the bill is heldresponsible for payment.

Disadvantages of Bill Discounting

(i) Payment of interest in advance. While discounting a bill, bank deducts the discountand 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 throughdiscounting of bill has to offer advance interest on the amount of the bill.

(ii) Facility is subjected to the creditworthiness of parties involved. Banks generallyextend this facility after being satisfied with thecreditworthiness of different parties involved. Incase of doubt,the bank may ask for some security. Thus, it is not a very easilyavailable facility.

(iii) Additional burden in case of non-payment. Bills not paid upon maturity are tobe certified by Notary Public and a certain amount in the form of noting charges is paid. Thus, itbecomes an additional burden.

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


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(a) Merits

(i) Interest free. Amount offered as advance is interest free. Hence funds are availablewithout involving financial burden.

(ii) No tangible security. The seller is not required to deposit anytangible 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. Hencethere are no repayment obligations.

(b) Demerits

(i) Limited amount. The amount advanced by the customer is subject to the value of theorder. 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 thecondition that in case goods are not delivered on time, the order would be cancelled and theadvance 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 liketelevision, refrigerators as well as forindustrial goods. You might be aware of this system. Onlya smallamount of money is paid at the time of delivery of such articles.The balance is paid in anumber of installments. The supplier chargesinterest for extending credit. The amount of interestis includedwhile deciding on the amount of installment. Another comparable system is the hirepurchase system under which the purchaserbecomes owner of the goods after the payment oflast installment.Sometimes commercial banks also grant installment credit if they have suitablearrangements with the suppliers.Advantages and disadvantages of this systemare given below:

(a) Advantages

(i) Immediate possession of assets. Delivery of assets is assured immediately onpayment of initial installment (down payment).

(ii) Convenient payment for assets and equipment. Costly assets and equipment whichcannot be purchased due to inadequacy of long-term funds can be conveniently purchased onpayment by installments.


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(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 creditleads 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 isavailable. Thus, expansion and modernization of business and office are facilitated byinstallment credit.

(b) Disadvantages

(i) Committed expenditure. Payment of installment is a commitmentto pay irrespective of profit or loss in the business.

(ii) Obligation to pay interest. Under installment credit system payment of interest ofobligatory. Generally sellers charge a high rate of interest.

(iii) Additional burden in case of default. Sellers sometimes impose stringentconditions in the form of penalty or additional interest, if the buyer fails to pay the installmentamount.

(iv) Cash does not flow. Like trade credit, installment credit facilitates the purchase of assetor 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 havebeen established at local, district andstate levels. District Cooperative Banks are the federationof primary credit societies. The State Cooperative Bank finances and controls the DistrictCooperative Banks in the state. These banks grant loans for personal as well as businesspurposes. Membership is the primary condition for securing loan. The functions of these banksare largely comparable to the functions of commercial banks.

(a) Benefits

(i) Loans from co-operative banks are easily available to farmers and small businessmeninvolving minimum formalities.

(ii) Co-operative banks provide a convenient means of borrowing. Loans are generallygranted at a lower rate of interest.

(iii) Sometimes co-operative banks organize training programmes for members to familiarizethem with the various avenues of business and regarding proper utilization of loan money.


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(iv) Being a member of a cooperative bank, the borrower can participate in the managementand 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 financialand social status of the people.

(b) Drawbacks

(i) 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 inadequateinformation about the need and utilization of funds by the borrower. There is little scrutiny of therepaying capacity of the loan seeker at the time of granting loan.

(iii) Inadequate resources and lack of trained personnel for management have restricted thespread of co-operative banking facilities.

(iv) Co-operative banks depend largely on the support of the Government. ThereforeGovernment 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 Finance21. 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 organizationskeep away from such loans because of uncertainty and other reasons. Let us examine the meritsand 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 anddoes 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 whenrequired. These can be paid back if not required. This provides flexibility.

(iii) No Interference in Management. The lenders of short-term finance cannot interferewith the management of the borrowing concern. The management retain their freedom indecision making.


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(iv) May also serve long-term purposes. Generally business firms keep on renewingshort-term credit, e.g., cash credit is granted for one year but it can be extended upto 3 years withannual review. After three years it can be renewed. Thus, sources of short-term finance maysometimes provide funds for long-term purposes.

(b) Demerits of Short-Term Finance. Short-term finance suffers from a few demeritswhich are listed below:

(i) Fixed Burden. Like all borrowings interest has to be paid on short-term loansirrespective of profit or loss earned by the organization. That is why business firms use short-term finance only for temporary purposes.

(ii) Charge on Assets. Generally short-term finance is raised on the basis of security ofmoveable assets. In such a case the borrowing concern cannot raise further loans against thesecurity 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 ofhuge amount or market demand is declining or industry is in recession, it loses itscreditworthiness. In such circumstances they find it difficult to borrow from banks or othersources of short-term finance.

(iv) Uncertainty. In cases of crisis business firms always face the uncertainty of securingfunds from sources of short-term finance. If the amount of finance required is large, it is alsomore uncertain to get the finance.

(v) Legal Formalities. Sometimes certain legal formalities are to be complied with forraising finance from short-term sources. If shares are to be deposited as security, then transferdeed 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 financeinvestment project. They can issue debt or equity securities to archive this goal. Sometimes leaseis also used as an alternative for long term financing. The source of finance has an implication oncost of funds. To this end this chapter discusses the different sources of finance including theirmerits and demerits.

Definition

23. This refers to finance that is needed over a long period of time - certainly over a year andpossibly over many years. It tends to be used for financing the setting up of businesses and forexpansion of existing businesses.

Long Term Sources of Finance


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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 thoserelating 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 premisesin another part of the UK, maybe they have a new product that they want to develop and maybethey want to buy another company. The methods of financing these types of projects willgenerally 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 offinance but a number of sources. There might be a dominant source of funds but when you areraising 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 includecommon stock and preferred stock. These two forms of securities provide a residential claim onthe income and assets of a corporation. Thus, this section discusses these two sources of long-

term finance.

(a) Common Stock Financing. The common stockholders of a corporation are its residualowners; their claim to incomeand assets comes after creditors and preferred stockholders havebeen paid in full. So common stock holders assume the ultimate risk associated with thecorporation.Advantage and disadvantages of common stock financing are as follows:-

(i) Advantages of Common Stock


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Common stock does not obligate the firm to make payments to

stockholders. A firm cannot be obliged to pay divided when there arefinancial constraints. Had it used debt, it would have incurred a legalobligation to pay interest regardless of operating condition and cash flows.

Common stock has no fixed maturity date. It never has to be rapid aswould a debt issue.

Common stock protects creditors against losses and hence, the sale ofcommon stock increases the creditworthiness of the firm. This in turnraises it bond rating, lowers its cost of debt and increases its future abilityto use debt. One of the costs of issuing debt is the possibility of financialfailure. This possibility does not arise when debt is used.

(ii) Disadvantages of Common Stock

The cost of underwriting and distributing common stock is usually higherthan that of preferred stock or debt

If the firm has more equity than required in its optimal capital structure, itscost of capital will be higher than necessary. Therefore, a firm would notwant to sell stock if the sale would cause its equity ration to exceedoptimal level

Under current tax laws, dividends on common stock are not deductible fortax purposes, but interest is deductible. This raises the relative cost ofequity as compare to debt.

(b) Preferred Stock Financing. Preferred stock differ from common stock becauseit has preference over common stock in the payment of dividends and in the distribution ofcorporation assets in the event of liquidation. Preference means only that the holders of thepreferred shares must receive a dividends (in the case of an ongoing firm) before holders ofcommon share are entitled toanything. Preferred stock is a form of equity form a legal and taxstand point. It isimportant to note. However, the holders of preferred stock sometimes have novoting 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 ofdebt 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 bankruptcyif earnings are too low to meet these fixed charges. This is because preferred stock earners adividend but the company has discretionary power to pay it. The omission of payment doesntresult in default.


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(ii) Disadvantages of Preferred Stock

It has a higher after tax cost of capital that debt. The major reason for this higher cost is taxespreferred dividends are no deductible for tax purpose, whereas interest expense on debt isdeductible.

Debt Financing

Bond

28. A debt investment in which an investor loans money to an entity (corporate orgovernmental) that borrows the funds for a defined period of time at a fixed interest rate. Bondsare used by companies, municipalities, states and U.S. and foreign governments to finance avariety 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 thesefactors play a role in determining the value of a bond and the extent to which it fits in yourportfolio.

(a) Face Value/Par Value. The face value (also known as the par value or principal) isthe amount of money a holder will get back once a bond matures. A newly issued bond usuallysells at the par value. Corporate bonds normally have a par value of $1,000, but this amount canbe much greater for government bonds.

(b) Coupon (The Interest Rate). The coupon is the amount the bondholder willreceive as interest payments. It's called a "coupon" because sometimes there are physicalcoupons on the bond that you tear off and redeem for interest. However, this was more commonin 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 principalwill be repaid. Maturities can range from as little as one day to as long as 30 years (though termsof 100 years have been issued). A bond that matures in one year is much more predictable andthus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time tomaturity, the higher the interest rate. Also, all things being equal, a longer term bond willfluctuate more than a shorter term bond.

(d) Issuer. The issuer of a bond is a crucial factor to consider, as the issuer's stabilityis your main assurance of getting paid back. For example, the U.S. government is far moresecure than any corporation. Its default risk (the chance of the debt not being paid back) isextremely small - so small that U.S. government securities are known as risk-free assets. Thereason behind this is that a government will always be able to bring in future revenue through


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taxation. A company, on the other hand, must continue to make profits, which is far fromguaranteed. This added risk means corporate bonds must offer a higher yield in order to enticeinvestors - 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 isfully tax deductible. Dividends paid to stockholders are not tax deductible. This makes debtfinancing 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 theasset of the firm. This action can result in liquidation or reorganization tow of the possibleconsequences of bankruptcy. Thus one of the costs of issuing debt is the possibility of financingfailure. This possibility does not exist when equity is issued.

Lease Financing

33. Leasing is an important source of equipment financing. For some equipment, thefinancing is long term in nature. A lease is a contract whereby the owner of an asset (the leaser)grants to another party (theleasee) the executive right to use the asset in return for the paymentof rent (i.e. leasepayment). In other words, through leasing, a firm can obtain the use of certainfixed assets for which it must make a series of contractual periodic payments form the leasepoints of view; this lease payment is tax deductible. Here we discuss lease as an alternativesource offinancing 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. Theterm of this type of lease is shorter than the assets economic life. Operating leases for instancemay include the leasing of copying machines certain computer hardware and word processors. Incontrast to an operating lease a financial lease is longer term in nature and is noncancelable. Thelessee is obligated to make lease payments until the lease term expires which approaches theuseful life of the asset.

35. If an operating lease is held until the term of the lease, at the maturity date will return theleased asset to the owner (leassor) who may lease is again or sell the asset. However, if the leaseedecides to return the asset before maturity (i.e. cancel the lease) it may be required to pay apredetermined penalty for cancellation.

36. In case of financial lease the leasee cannot cancel the lease contract and is obligated tomake leasee payment over the term of the lease regardless of whether the leasee needs the


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service of the asset or not. But at the maturity date, the lease may transfer ownership of the assetto the lessee or they may have the opportunity to purchase the leased asset at a bargain price. Forcapital (or financial) lease the value of asset along with the corresponding lease liability must beshown on the balance sheet. Capital leases are commonly used for leasing land, buildings and bigequipment.

Conditions

37. More specifically, a lease is considered as a capital (or financial) lease if it meets any oneof the following conditions:

(a) The lease transfers title to the assets to the leasee by the end of lease period

(b) 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 paymentsequal 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 oftime, 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 increasingthe 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 purchaseof the asset (borrower as well) is required to pay a portion of the purchase price as a downpayment.

(d) In a lease arrangement, the leasee may avoid the cost of obsolescence if the lessorfails to accurately anticipate the possibility for obsolescence of the asset and set the less paymenttoo low.

Disadvantage of Leasing

(a) A lease does not have a stated interest cost. Besides at the end of the term of thelease agreement, the salvage value of an asset, if any, is realized by the leaser. Thus in many ofthe leases, the return to the lessor is quite high.


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(b) In a lease of an asset that subsequently becomes obsolete, under a capital lease theleasee still makes lease payments until maturity.

Shares

39. A share is a part ownership of a company. Shares relate to companies set up as privatelimited companies or public limited companies There are many small firms who decide to setthemselves 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 thebusiness.

40. If the business wants to expand, they can issue more shares but there are limitations onwho they can sell shares to - any share issue has to have the full backing of the existingshareholders. PLCs are different. They sell shares to the general public. This means that anyonecould buy the shares in the business.

41. Some firms might have started out as a private limited company and have expanded overtime. There might come a time when they cannot issue any more shares to friends or family andneed more funds to continue expanding. They might then decide to become a public limitedcompany. This is called 'floating the business'. It means that the business will have to go througha number of administrative and legal procedures to allow it to be able to offer shares to thegeneral public.

42. It might be that a business wants to raise 300 million to finance its expansion plans. Itmight issue 300 million 1 shares in the company. The offering of these shares has to beaccompanied by a prospectus which lays out details of the business - what it is involved in, howit is structured, how it will be managed and so on. This is so that prospective investors, people orinstitutions who might want to buy the shares, can get information about the company beforecommitting to buying shares.

43. Once the shares are sold, share owners can buy and sell their shares through the stockexchange. Such buying and selling does not affect the business concerned directly and is one ofthe main advantages of the stock exchange. There may be times in the development of a plcwhen it needs to raise more funds. In this case it can issue more shares. Many firms will do thisthrough what is called a 'rights issue'. This occurs where new shares are issued but existingshareholders get the right to purchase new additional shares at a reduced price. If the business isdoing well and the new finance is needed for expansion, this can be an attractive proposition forexisting shareholders. For the business it is a relatively quick and cheap way of raising newfunds.

Debentures

44. Debenture means a document issued by the company as an acknowledgement ofindebtedness to its debenture-holders and giving an undertaking to repay the debt at a specifieddate 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


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rate and at the intervals stated in the debenture. No voting rights are given to the debentureholders. 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 ofthe company.

(b) Capital raised by way of debentures is required to be repaid during the life time of thecompany at the time stipulated by the company. Thus, it is not a source of permanent capital.

(c) Debentures are generally secured.

(d) Return paid by the company is in the form of interest which is predetermined.

(e) Debentures are very risky from companys point of view for raising long term funds.

(f) Risk on the part of debenture holders is very less.

(g) Debenture holders do not carry any voting rights.

(h) 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 guaranteedpayments 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 generalmeeting.


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(b) Debentures are more secure than stocks, but will lead to a lower rate of theoreticalreturn.

(c) It is a type of debt instrument which is not secured by collateral (or physical asset). Incase 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 aproject (in this case - a business) where there is a substantial element of risk relating to the futurecreation of profits and cash flows. Risk capital is invested as shares (equity) rather than as a loanand 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 "businessangels" - private investors. Separate Tutor2u revision notes cover the operation of businessangels. 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 potentialinvestments are often very similar.

50. Venture capital provides long-term, committed share capital, to help unquoted companiesgrow and succeed. If an entrepreneur is looking to start-up, expand, buy-into a business, buy-outa business in which he works, turnaround or revitalize a company, venture capital could help dothis. 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 thesuccess or failure of a business. Venture capital is invested in exchange for an equity stake in thebusiness. As a shareholder, the venture capitalist's return is dependent on the growth andprofitability of the business. This return is generally earned when the venture capitalist "exits" byselling 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 notnecessarily mean small or new businesses. Rather, it is more about the investment's aspirationsand potential for growth, rather than by current size. Such businesses are aiming to grow rapidlyto a significant size. As a rule of thumb, unless a business can offer the prospect of significantturnover 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 aremanaged by experienced and ambitious teams who are capable of turning their business plan intoreality.

For how long do venture capitalists invest in a business?

52. Venture capital firms usually look to retain their investment for between three and sevenyears 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


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quicker and easier, are often sold sooner than investments in early-stage or technologycompanies 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. Banksmay 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 whichthe Bank of England sets interest rates. For businesses, using bank loans might be relatively easybut the cost of servicing the loan (paying the money and interest back) can be high. If interestrates 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 shopmight want to move to larger premises. They find a new shop with a price of 200,000. To raisethis sort of money, the bank will want some sort of security - a guarantee that if the borrowercannot 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 takingout a second mortgage. If the business does not work out and the borrower could not pay thebank the loan then the bank has the right to take the home of the borrower and sell it to recovertheir money. Using a mortgage in this way is a very popular way of raising finance for smallbusinesses 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 helpset up their business. The money may be the result of savings, money left to them by a relative ina will or money received as the result of a redundancy payment. This has the advantage that itdoes not carry with it any interest. It might not, however, be a large enough sum to finance thebusiness 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 inexistence. 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 - usuallyexpressed 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 particularbusiness is. In the early stages of business growth, it may be necessary to put back a lot of theprofits into the business. This finance can be used to buy new equipment and machinery as well


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as more stock or raw materials and hopefully make the business more efficient and profitable inthe 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 abusiness to sell off some of these assets to finance other projects.

60. In October 2006, the Thomson Corporation announced that it would be selling ThomsonLearning. Part of the reasoning was that the learning part of the business was different to otherparts of the corporation and that it did not fit into the strategic direction which the corporation asa whole wanted to go in. Selling Thomson Learning will help to raise valuable funds for the restof the corporation to be able to develop. It is estimated that Thomson Learning will be worthsomething 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 ofbusiness. 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 EdenProject are a not for profit business so any surplus they make is put back into the business to helpdevelop and improve it.

Conclusion

Firms have different alternative sources of long term finance including equity debt andlease. Equity financing could simply mean raising long term funds by selling common orpreferred 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 similarto borrowing. There are two types of lease agreements. These are operating lease andcapital (or financial lease).The principal factor affecting the decision to use equity or bond financing is tax. Dividendson equity are not tax deductible whereas interest on debt is deductible. This raises therelative cost of equity compared to debt.7


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Documents

short term & long term finances