Business finance
Sources and choices
Business finance comes from internal retained earnings or external equity and debt. Equity includes ordinary shares, rights issues and venture capital; debt includes bank loans, overdrafts, loan notes, leases and convertible securities. Short-term finance suits seasonal working capital; long-term finance suits assets with long lives. Debt is usually cheaper due to tax relief and lower risk but raises financial risk and fixed obligations. Equity avoids compulsory payments but dilutes control and may signal overvaluation. A rights issue offers existing shareholders new shares at a discount, preserving pre-emption rights. Convertibles and warrants combine debt with future equity participation.
Traps and rule of thumb
Traps: assuming the cheapest source is best without considering risk, control and maturity matching; ignoring issue costs; forgetting that a rights issue reduces the theoretical ex-rights price. Use the TERP formula: market value of existing shares plus proceeds of issue, divided by total shares after issue.
Worked example: a company has four existing shares at $5 each and makes a one-for-four rights issue at $2. TERP = (4 times $5 + 1 times $2) / 5 = $22/5 = $4.40. The existing shareholder's wealth is unchanged before transaction costs: four old shares worth $20 become five shares worth $22, plus the right to subscribe $2.
Rule of thumb: match the source to the asset's life and risk, compare all-in after-tax cost, and check covenants, security, dilution and flexibility before recommending finance.