There are two ways through which a business can finance itself, on a short term basis and long term. Short term sources are those which include bank overdrafts, bank loans, having better working capital, leasing and availing the trade credits. Leasing, particularly operating lease is classified as a short term source of finance. Operating lease is in which the lease period is less than the asset’s useful life. It is short of a rental arrangement. Long term finance is done through various different ways. One of it is equity method. By equity method it means ownership in the business through ordinary shares only.
Preference shares are not considered to be a part of equity source of finance. Right issue is another way how finance can be raised but to the existing shareholders only. Through equity method shareholders get a control over the business and can influence decision made by the business. Debt is another source of long term finance. Loan notes, debentures and bonds are considered to be the sources classified under debt financing. Loan notes can be redeemable as well as irredeemable. Mostly debts have to be paid a certain amount of interest as well as principal.
In case of irredeemable debts they are not be paid on a specific time in future but the interest is paid. Another way of raising long term finance is through convertibles. Convertibles have both element of equity and debt in it. After a period of time these loan notes are converted into ordinary shares. Finance leasing is another way of long term financing. In this type of lease the asset is used by the lessee almost for the whole useful life. Another way is the venture capital. They provide a certain amount at the start of the business and then at a period where the business is in its growth (Eugene & Michael, 2010).
b) Access the implication of the above mentioned sources in terms of legal, financial and dilution of control implications, and bankruptcy. It is important to understand that all sources of finance have different characteristics and their pros and cons. The businessman must need to assess the problems or advantages of any particular source of finance before utilizing it in the business. Take an example of shareholders equity the initial public offering may be a good idea when the company has to expand its business but at the same time the company must acknowledge the legal cost associated with it such as sec requirements.
Also equity causes dilution of ownership on the other hand taking lots of liability put the business on risk because sometimes the business finds itself too difficult to even pay its interest on loans and so may be liquidated c) Case Study: You are the Financial Manager of a company who wants to construct a dam in Bangladesh. You are required to advice you company on the most appropriate source of Finance assuming 1. The dam will require a minimum of 10 years to construct 2. You have no experience of working in Bangladesh There are many ways in which a business can be financed.
But as the minimum period required for the construction is 10 years than long term financing would be appropriate. Now deciding what type of long term finance should be chosen depends on the current market situations of Bangladesh. As the company has no such experience in Bangladesh it would be better first to look at the similar projects in the country. As it is the first project in Bangladesh it would be better to finance the project through a ratio of equity and debt. As debt is a cheaper source of finance it would be easy to avail it, but when considering the debts, the interest rates should be taken into consideration.
The most possible investors in this case can be the banks, venture capital and those wealthy people who invest into business for the sake of return in the form of equity. These types of people are also known as the business angels. Borrowing can be done on long term with the banks to facilitate the business with the cheap source of finance. Leasing is another way, particularly operating lease where the assets will be owned by the business and if at the end they are not needed they can be sold. Risk and rewards should be considered before choosing the financing method.
Risks can be of two types, business and financial. Business risk varies from industry to industry, so it is important to have knowledge about the already established industries in the same field. Financial risks are controllable risks which relate particularly to a business and due to its long terms borrowings. As the company will have to pay interest it will have to cut down on its dividends. Therefore a mix of both equity and debt financing would be a better way to finance the business. In case of raising funds through debts the financial risk increases while it’s vice versa in the case of equity.
Another advantage of issuing debt as a source is that there will be tax savings and it will decrease the cost of capital. 2 A) Access and compare the costs of different sources of finance. The cost of different sources of finance depends on two factors. Risk free rate in the market and the rewards required by the investors. Investors are ready to take risk only when the rewards are high. The cost of equity can be measured using different models like dividend valuation method, capital asset pricing model, etc. and the cost of debt can be measured through different methods. Basically the cost of debt is lower than that of equity.
It is considered to be the cheaper source of finance as it has high risk. And the most important thing it helps in saving tax. B) What is the importance of financial planning in relation to cash budgeting and avoiding overtrading? Planning is important at all stages of the business. Financial planning in relation to cash budgeting is done when the business is already started. Through financial planning a rough estimate is made in the beginning what the cash flows will be made during a certain period. It limits the business according to the available resources. It then provides as a control and also compares the performance of the business.
C) What are the information needs of different decision makers? Any information needed by the decision makers should be ACCURATE. The information should be accurate in terms of numbers as well as other terms. The information needed should be complete in all aspects. It should be correct, user friendly which means the user should be able to understand it. It should be reliable from a source which has some value. It should be timely available, that is should be there when needed by the user. Most importantly the information should be effective, which is it should have all the contents a user needs to make a decision about.