This article considers the practical issues facing a business when selecting appropriate sources of finance. It does not consider the theoretical aspects of such decisions (Modigliani and Miller), nor does it provide detailed descriptions of various sources of finance. These are well covered in manuals and textbooks. Show A business faces three major issues when selecting an appropriate source of finance for a new project:
Can the necessary finance be provided from internal sources? In answering this question the company needs to consider several issues:
Pressurising debtors for early settlement, running down stock levels and lengthening the payment period to creditors could increase cash resources. Note however, there are dangers in such tactics. For example, lost customer/supplier goodwill and production stoppages due to running out of stock etc. If the necessary finance cannot be provided internally then the company has to consider raising finance externally. The debt or equity decision
After consideration of the above points the company will be in a position to decide between the use of debt or equity finance. The last major decision is what type of finance should be used and where should it be raised? Equity finance
Debt finance The duration of the loan In choosing between short-term and long-term borrowing, the firm should consider the textbook rule of thumb for prudent financing: ‘finance short-term investments with short-term funds and long-term investments with long-term funds’. Simply, this means use cheap short-term borrowing where it is safe to do so (investments that are short-term in nature and hence renewal risk is not a problem) but use long-term finance for long-lived investments. Fixed v floating-rate borrowing The status of the company Currency of borrowing Debt covenants Conclusion Example 1 ABC plc needs $100m over the coming year to finance an expansion of the business. Accounting statements for the last financial year are given below. Without the expansion sales turnover, cost of sales (excluding depreciation), dividends and working capital requirements are expected to grow by 10% in the coming year. The corporation tax bill is expected to be $120m. Tax and dividends are paid nine months after the year end. Required: Calculate ABC’s expected net cash flow for the year ending 30 June 20X4 without the new investment. Comment on the amount of external financing required for the proposed expansion. (Note: a statement in FRS 1 format is not required). Solution Comment What inventory management procedure helps a firm to control inventory costs quizlet?What inventory management procedure helps a firm to control inventory costs? Funding day-to-day operations, acquiring needed inventory, and making capital expenditures are all needs for funds in an organization.
Which are forms of debt financing?Debt financing includes bank loans; loans from family and friends; government-backed loans, such as SBA loans; lines of credit; credit cards; mortgages; and equipment loans.
What is the main advantage in debt financing?A big advantage of debt financing is the ability to pay off high-cost debt, reducing monthly payments by hundreds or even thousands of dollars. Reducing your cost of capital boosts business cash flow.
What information is specified in the loan agreement for a line of credit?Loan agreements typically include covenants, value of collateral involved, guarantees, interest rate terms and the duration over which it must be repaid.
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