Sources of Business Finance - Study Guide
This domain tests how a business raises funds and how it chooses between owner's funds and borrowed funds. Expect classification of sources by maturity, ownership and security, plus reasons for choosing equity, debt, retained earnings or hybrid finance.
Core ideas
- Owner's funds: equity share capital and retained earnings; permanent, residual claim, no fixed dividend, but control may dilute.
- Borrowed funds: term loans, debentures and bonds, trade credit and working-capital loans; fixed interest and repayment obligations, often secured.
- Equity issue routes: initial public offer, further public offer, rights issue to existing shareholders, private placement.
- Internal sources include retained earnings and sale of assets; external sources include loans, debentures and new shares.
- Match maturity: short-term needs with trade credit or cash credit; long-term assets with equity or term debt.
- Choice depends on cost, risk, control, flexibility and cash-flow timing; debt interest is tax-deductible, but debt raises financial distress risk.
Worked example
A firm needs ₹50 lakh for five years. A bank loan costs 11% pre-tax; the tax rate is 25%, so after-tax cost is 11% × (1 − 0.25) = 8.25%. Equity investors expect a 14% return. On cost alone, debt looks cheaper. But the loan creates fixed interest and principal payments and may impose covenants; a downturn could cause default. The decision must compare the 8.25% after-tax cost with financial risk and loss of flexibility, not just the 14% equity expectation.
Traps
Debt is not always cheaper after considering distress. A rights issue is not a public offer to new investors. Debentures are debt, not ownership. Do not use short-term finance for a long-term asset. Retained earnings are not free; they have an opportunity cost to shareholders.