Companies have different alternatives for obtaining funds that is used to finance investment project. They can issue debt or equity securities to archive this goal. Some times lease is also used as an alternative for long term financing. The source of finance has an implication on cost of funds. To this end this chapter discusses the different sources of finance including their merits and demerits.
A company can raise finance in the following ways: From finance classified according to the relationship to the party giving the finance, e.g.
Equity Finance- This is finance provided by real owners of the business i.e. ordinary shareholders. Equity securities represent ownership interest in a corporation. These securities include common stock and preferred stock. These two forms of securities provide a residential claim on the income and assets of a corporation. Thus, this section discusses these two sources of long-term finance.
Quasi equity- This is finance provided by quasi-owners of the business i.e. preference shareholders.
Debt finance– This is finance provided by outsiders i.e. creditors: thus it include loans, overdrafts, trade creditors, bills of exchange, debentures, hire-purchase, leases, mortgages, etc.
Classified according to the duration i.e. term of finance i.e. how long the finance will be in the business.
Permanent finance– This is finance which cannot be refunded to the owners in the short-run. Examples of this finance are:
Ordinary share capital
Irredeemable preference share capital
Irredeemable debentures These are only refunded in the event of the company’s liquidation.
Long term finance– If finance is in the business for a period of 7 years and beyond, this finance is long-term, e.g. long-term debt finance. However, this term is relative because for a kiosk a 2 years loan is long-term, and for a limited company a 2 years loan is short term.
Short term finance– this is finance due to be refunded to lenders after a short period i.e. a period between one year and three years, e.g. overdrafts, short term loans, etc.
Classified according to the origin of finance:
Internal sources of finance- these are such finances as generated within the business, i.e. from the businesses’ own operations. Examples of such finances are; Retained earnings, Provision for depreciation
Provision for taxation
Adjustment in working capital items
The above finances are used as follows:-
i) Undistributed profits transferred to the business i.e. ploughed back into the business.
ii) Provision for depreciation if a company has created a sinking fund to replace an asset after useful economic life. This finance can be used and replaced later when the asset is due to be replaced.
iii) Provision for taxation is a source of finance in as much as the tax liability falls due a bit later than when it is appropriated from the current profits, e.g. a company will provide for taxation in December and pay it at the end of March or thereafter. i.e. can be used up to the end of March.
Adjustment in working capital serves as a source of finance in as much as the company will reduce the levels of working capital items to release finance which would have otherwise been tied up in those items.
Sale of an asset; this is a source of finance under the following conditions:-
i) If the asset is obsolete
ii) If the asset is sensitive to technology e.g. computers, aircrafts.
iii) If the asset cannot meet the company’s contemplated expansion programme.
iv) If the asset is not sensitive/ central of the company’s operations, and its sale will not substantially affect he productive capacity of the business.
Classification according to the rate of return i.e. in relation to the cost of that finance.
Finance with variable rate of return VRT). In this case the return on such finance will vary with the profits made by the company; e.g. ordinary share capital and participative preference share capital are VRT.
Fixed rate of return capital (WFR). This will refer to the finance whose rate of return is fixed regardless of the profits made, e.g. preference share capital, loan finance, debenture finance etc