Business Finance: Sources of Finance and Capital Structure
Sources of Finance
Businesses need finance for startup, expansion, working capital, and asset purchases. Sources are classified as internal (retained earnings, sale of assets) or external (debt, equity, grants). Short-term sources (overdrafts, trade credit) are for day-to-day needs; long-term sources (bank loans, bonds, equity) fund strategic investments.
Debt finance (loans, bonds) involves borrowing with interest and repayment; it does not dilute ownership but increases financial risk. Equity finance (issuing shares) raises capital without repayment obligations but dilutes ownership and control. Hybrid sources like convertible bonds combine features of both.
Capital Structure
Capital structure is the mix of debt and equity used by a firm. The Modigliani-Miller theorem (without taxes) suggests capital structure is irrelevant to firm value. With taxes, debt is advantageous due to the tax shield on interest. However, excessive debt increases financial distress costs. The trade-off theory balances tax benefits against bankruptcy costs. Pecking order theory suggests firms prefer internal financing first, then debt, then equity.
Traps
A common trap is assuming equity is always cheaper than debt. In fact, equity is often more expensive due to higher required returns by shareholders. Another trap is ignoring the impact of gearing (debt-to-equity ratio) on risk and cost of capital.
Worked Example
A company needs £1 million for expansion. It can issue debt at 6% interest or equity. The corporate tax rate is 20%. The after-tax cost of debt is 6% * (1 - 0.20) = 4.8%. If equity investors require a 10% return, debt is cheaper. However, if the company already has high gearing, additional debt may increase financial risk and raise the cost of both debt and equity. The firm should assess its optimal capital structure.
Rule of Thumb
Use the pecking order: retained earnings first, then debt, then equity. Match the source to the use: short-term assets with short-term finance, long-term assets with long-term finance.