3rd March 2011

Sources of Finance
For many businesses, the issue about where to get funds from for starting up, development and
expansion can be crucial for the success of the business. It is important, therefore, that you
understand the various sources of finance open to a business and are able to assess how appropriate
these sources are in relation to the needs of the business. The latter point regarding 'assessment' is
particularly important at A2 level where you are expected to make judgements.

Internal Sources
 Traditionally, the major sources of finance for a limited company were internal sources:
 Personal savings
 Retained profit
 Working capital
 Sale of assets

External Sources

Ownership Capital
In this context, 'owners' refers to those people/institutions who are shareholders. Sole traders and
partnerships do not have shareholders - the individual or the partners are the owners of the
business but do not hold shares. Shares are units of investment in a limited company, whether it be
a public or private limited company. Shares are generally broken down into two categories:

 Ordinary shares
 Preference shares

Non-Ownership Capital
Whilst the following sources of finance are important, they are not classed as Ownership Capital -
Debenture holders are not shareholders, nor are banks who lend money or creditors. Only
shareholders are owners of the company.

 Debentures
 Other loans
 Overdraft facilities
 Hire purchase
 Lines of credit from creditors
 Financial structures of four well known British companies
 Grants
 Venture capital
 Factoring and invoice discounting:
 Factoring
 Invoice discounting
 Leasing

X----------------------X------------------------X-----------------------X
Sir’s notes:

Short Term Finance:

1. Account Payable or Creditors
2. Bank Over Draft
3. Cash credit
4. Bills Payable
5. Letter of Credit
6. Notes Payable

 Working capital is use to pay off short term debts. Not use for investing purpose
 A bank overdraft is a limit on borrowing on a bank current account. With an overdraft the
amount of borrowing may vary on a daily basis.
 A cash credit is a short-term cash loan to a company. A bank provides this type of funding,
but only after the required security is given to secure the loan. Once a security for
repayment has been given, the business that receives the loan can continuously draw from
the bank up to a certain specified amount. -prearranged loan that a business does not have
to take until it is needed.
 Bills Payable is Similar to accounts payable, this term is used to describe a bank's
indebtedness to other banks, principally a Federal Reserve Bank, that is backed by collateral
consisting of the bank's promissory note and a pledge of government securities. In other
words, bills payable is the money a bank borrows, mainly on a short-term basis, and owes to
other banks.
 Letter of Credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be
received on time and for the correct amount. In the event that the buyer is unable to make
payment on the purchase, the bank will be required to cover the full or remaining amount of
the purchase.
 Notes payable represent obligations to banks or other creditors based on formal written
agreements.

Q: What is the difference between overdraft and cash credit?

Answer: The difference is very subtle and relates to the operation of the account. In the case of
Cash Credit, a proper limit is sanctioned which normally is a certain percentage of the value of the
commodities/debts pledged by the account holder with the Bank. Overdraft, on the other hand, is
allowed against a host of other securities including financial instruments like shares, units of mutual
funds, surrender value of LIC policy and debentures etc. Some overdrafts are even granted against
the perceived "worth" of an individual. Such overdrafts are called clean overdrafts.

Cc is a permanent limit given by the bank and over draft is given for a particular period like 10 days
15 days or so and it is done in current a/c.

C/C a/c is permanent & OD is temporarily.

Q: What Does Capital Structure Mean?
Answer: A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity. The capital structure is how a firm finances its overall operations and growth
by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure.

So;

 Common Stock (ordinary shares)

A security that represents ownership in a corporation. Holders of common stock exercise

control by electing a board of directors and voting on corporate policy. Common
stockholders are on the bottom of the priority ladder for ownership structure. In the event
of liquidation, common shareholders have rights to a company's assets only after
bondholders, preferred shareholders and other debtholders have been paid in full.

 Preferred Stock

A class of ownership in a corporation that has a higher claim on the assets and earnings than
common stock. Preferred stock generally has a dividend that must be paid out before
dividends to common stockholders and the shares usually do not have voting rights.

The precise details as to the structure of preferred stock is specific to each corporation.
However, the best way to think of preferred stock is as a financial instrument that
has characteristics of both debt (fixed dividends) and equity (potential appreciation). Also
known as "preferred shares".

 Bond

In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt
and, depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to
repay the principal at a later date, termed maturity. A bond is a formal contract to repay
borrowed money with interest at fixed intervals. [1]

Thus a bond is like a loan: the issuer is the borrower (debtor), the holder is the lender
(creditor), and the coupon is the interest. Bonds provide the borrower with external funds to
finance long-term investments, or, in the case of government bonds, to finance current
expenditure. Certificates of deposit (CDs) or commercial paper are considered to be money
market instruments and not bonds.

Bonds and stocks are both securities, but the major difference between the two is that
(capital) stockholders have an equity stake in the company (i.e., they are owners), whereas
bondholders have a creditor stake in the company (i.e., they are lenders). Another difference
is that bonds usually have a defined term, or maturity, after which the bond is redeemed,
 whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a
perpetuity (i.e., bond with no maturity).

What Does Primary Market Mean?

A market that issues new securities on an exchange. Companies, governments and other groups
obtain financing through debt or equity based securities. Primary markets are facilitated by
underwriting groups, which consist of investment banks that will set a beginning price range for a
given security and then oversee its sale directly to investors.

What Does Secondary Market Mean?

A market where investors purchase securities or assets from other investors, rather than from
issuing companies themselves. The national exchanges - such as the New York Stock Exchange and
the NASDAQ are secondary markets.

Secondary markets exist for other securities as well, such as when funds, investment banks, or
entities such as Fannie Mae purchase mortgages from issuing lenders. In any secondary market
trade, the cash proceeds go to an investor rather than to the underlying company/entity directly.

What Does Third Market Mean?

Trading by non exchange-member brokers/dealers and institutional investors of exchange-listed
stocks. In other words, the third market involves exchange-listed securities that are being traded
over-the-counter between brokers/dealers and large institutional investors

What Does Over-The-Counter - OTC Mean?

A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX,
etc. The phrase "over-the-counter" can be used to refer to stocks that trade via a dealer network as
opposed to on a centralized exchange. It also refers to debt securities and other financial
instruments such as derivatives, which are traded through a dealer network.

What Does Fourth Market Mean?

The trading of exchange-listed securities between institutions on a private over-the-counter
computer network, rather than over a recognized exchange such as the New York Stock Exchange
(NYSE) or Nasdaq. Trades between institutions will often be made in large blocks and without a
broker, allowing the institutions to avoid brokerage fees.
10th March 2011:

Capital Structure:-

1. Common Stock
2. Preferred Stock
3. Bonds

What Does Cumulative Preferred Stock Mean?

A type of preferred stock with a provision that stipulates that if any dividends have been omitted in
the past, they must be paid out to preferred shareholders first, before common shareholders can
receive dividends.

What Does Noncumulative Preferred Stock Mean?

A type of preferred stock that does not pay the holder any unpaid or omitted dividends. If the
corporation chooses to not pay dividends in a given year, the investor does not have the right to
claim any of those forgone dividends in the future.

What does participative Preferred Stock Mean?

a type of preferred stock that entitles the holder to a fixed dividend and, in addition, to the right to
participate in any surplus profits after payment of agreed levels of dividends to holders of common
stock has been made.

Preferred Stock Common Stock

Fixed dividend Variable dividend
No voting right Voting right
Less risky High Risk
In case of liquidity, they are paid first before In case of liquidity they are paid in the last in full
common stock. settlement.

Preferred Stock Bonds

It is liquid instrument It is debt instrument
It receive dividends It receive interest
In case of liquidation, Preferred Stocks are In case of liquidation bonds are paid first of all.
settled after bond (debt) but before common
stock.

Similarities in between preferred Stock and Bonds

 Both get fixed rate of return.

 Both are redeemable (bought back)

Bonus Issue Right Issue

No payment is required Payment is required
It is issued on proportionate bases No ratio is required
Similarities between Bonds and Right Issue:

Both are issued to existing shareholder.

Disadvantage of Right issue:

Increase in the concentration of share can help shareholder to make his own terms.

THE MODIGLIANI–MILLER THEOREM (OF FRANCO MODIGLIANI, MERTON MILLER) FORMS

THE BASIS FOR MODERN THINKING ON CAPITAL STRUCTURE. THE BASIC THEOREM
STATES THAT, UNDER A CERTAIN MARKET PRICE PROCESS (THE CLASSICAL RANDOM
WALK), IN THE ABSENCE OF TAXES, BANKRUPTCY COSTS, AGENCY COSTS,
AND ASYMMETRIC INFORMATION, AND IN AN EFFICIENT MARKET, THE VALUE OF A FIRM IS
UNAFFECTED BY HOW THAT FIRM IS FINANCED.[1] IT DOES NOT MATTER IF THE FIRM'S
CAPITAL IS RAISED BY ISSUING STOCK OR SELLING DEBT. IT DOES NOT MATTER WHAT
THE FIRM'S DIVIDEND POLICY IS. THEREFORE, THE MODIGLIANI–MILLER THEOREM IS
ALSO OFTEN CALLED THE CAPITAL STRUCTURE IRRELEVANCE PRINCIPLE.

MODIGLIANI WAS AWARDED THE 1985 NOBEL PRIZE IN ECONOMICS FOR THIS AND OTHER
CONTRIBUTIONS.

MILLER WAS A PROFESSOR AT THE UNIVERSITY OF CHICAGO WHEN HE WAS AWARDED

THE 1990 NOBEL PRIZE IN ECONOMICS, ALONG WITH HARRY MARKOWITZAND WILLIAM
SHARPE, FOR THEIR "WORK IN THE THEORY OF FINANCIAL ECONOMICS," WITH MILLER
SPECIFICALLY CITED FOR "FUNDAMENTAL CONTRIBUTIONS TO THE THEORY OF
CORPORATE FINANCE."