Usually a percentage of the price is paid as down payment and the rest is paid in installments for the period of time agreed upon. 1,00,000 10% debentures at par; the before-tax cost of this debt issue will also be 10% By way of a formula, before-tax cost of debt may be calculated as: In case the debt is raised at premium or discount, we should consider P as the amount of net proceeds received from the issue and not the face value of securities. In case dividends are not paid to preference shareholders, it will affect the fund raising capacity of the firm. Corporate Citizenship T. Cohen, A. Bimha. 90 in the beginning of 2008, the current cost of existing debt may be computed as: Sometimes companies issue bonds or debentures at a discount from their eventual maturity value and having zero interest rate. This can range from 1 week to 90 days depending upon the type of business and industry. In case, the dividends of a firm are expected to grow at a supernormal growth rate, gs, for n years and then grow at a normal growth rate, gn, till infinity; the cost of equity share can be calculated as: The equity share of a company is currently selling at Rs. Finance is needed at every stage in the life of a business. The cost of issue is Rs. Sources of finance 1. The cost of such debt can be calculated by finding the present values of cash flows as below: (i) Prepare the cash flow table using an arbitrary assumed discount rate to discount the cash flows to the present value. On the basis of the period, the different sources of funds can be classified into three parts. The things to look here for are primarily the levels of debt in comparison to equity. Sources of finance ... (E.g. • Every business is a process of acquiring and disposing assets: – Real assets (tangible and intangible). • Finance is about the bottom line of business activities. Ploughed back profits 1. (ii) When the dividend pay-out- ratio is 100 per cent or when the retention ratio is zero, i.e., all the available profits are distributed as dividends. The business can benefit from the asset without purchasing it. Real or Inflation Adjusted Cost of Debt: In the days of inflation, the real cost of debt is much less than the nominal cost as the fixed amount is payable irrespective of the fall in the value of money because of price level changes. The appropriateness, advantages and disadvantages of sources of finance for a given situation AO2. Principles of Business Information Systems T. Chesney, G. Reynolds. Retained profits. 1.000 per bond sold at Rs. Some of them are essential for the operation of the site, while others help us to improve this site and the user experience (tracking cookies). 50,000 8% debentures at a discount of 5%. This method of computing cost of equity share capital is based upon the following assumptions: (a) The firm will remain in the same risk class over the period; (b) The shareholders’ expectations are based upon the past realised yield; (c) The investors get the same rate of return as the realised yield even if they invest elsewhere; (d) The market price of shares does not change significantly. Copyright 9. Further, if the prime lending rate falls to 6% p.a., the company shall pay interest at only 10% p.a. AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest The following illustration explains the procedure of determining the cost of zero coupon bonds. (iii) When a firm is expected to earn an amount on new equity shares capital, which is equal to the current rate of earnings. A business faces three major issues when selecting an appropriate source of finance for a new project: 1. If the prime lending rate of the bank is 8% p.a., the company will have to pay interest at the rate of 12% p.a. 10,00,000 10% redeemable debentures at a discount of 5%. Through this facility the customers can overdraw their accounts to a greater value than the balance in the account. (ii) Find out the net present value by deducting the present value of the outflows from the present value of the inflows. 2 per share. Cost of issue is Rs. Compute cost of debt capital. This method of computing cost of equity capital may be employed in the following cases: (i) When the earnings per share are expected to remain constant. Borrow Fund 1. The requirements of funds by business to carry out its various activities is called business finance. Popular books for Business and Economics. Cost of Retained Earnings. Luthans. The tax rate is 50%, Compute the cost of debt capital. Cash flow problems can arise if the bank asks for the overdraft to be repaid at a short notice. 100 each at par. As […] Long term Sources of Finance. 50,000 8% debentures at a premium of 10%. are as given below: (b) Shortcut Method to Compute Cost of Redeemable Debt: In order to avoid the complex calculations of hit and trial method, we can compute the approximate cost of redeemable debt by using the following simple formula: n = Number of years in which debt is to be redeemed. Calculate the real cost of debt. One of the serious limitations of using dividend yield method or earnings yield method is the problem of estimating the expectations of the investors regarding future dividends and earnings. Cost of Debt: i. Assuming that a firm pays tax at 50% rate, compute the after tax cost of debt capital in the following cases: (i) A perpetual bond sold at par, coupon rate of interest being 7%; (ii) A 10 year, 8% Rs. Uploader Agreement, Read Accounting Notes, Procedures, Problems and Solutions, Learn Accounting: Notes, Procedures, Problems and Solutions, Equity Share: Advantages and Disadvantages | Finance Sources, Difference between Shares and Debentures | Finance Sources, Top 6 Characteristics of Equity Shares | Finance Sources, 7 Main Steps for Installation of a Costing System. The impact of sources of finance on financial position. Cost of Debt Redeemable in Installments: Financial institutions generally require principal to be amortised in installments. Trade Credit: Usually in business dealing supplier give a grace period to their customers to pay for the purchases. Study notes. Businesses can raise capital through various sources of funds which are classified into three categories. © 2020 These sources of finance can be classified as: Internal: this is money raised from inside the business. The total cost of leasing may end up higher than the purchasing of asset. 100 each. It is, thus, the opportunity cost of dividends foregone by the shareholders. Purchasing and Supply Chain Management R. Monczka. Notes Paper exam. A five year Rs. 2. Each month, the entrepreneur pays for various business-related expenses on a credit card. 60 lakhs for expanding its operations. Sources of finance for business are equity, debt, debentures, retained earnings, term loans, working capital loans, letter of credit, euro issue, venture funding etc. 1. A business might have access to various sources of financing its needs. Sources of Finance The financing of your business is the most fundamental aspect of its management. The firm’s tax rate is 35 per cent. Through this facility the customers can overdraw their accounts to a greater value than the balance in the account. Personal funds . The amount of interest goes on decreasing each period as it is calculated on the outstanding amount of debt. To make adjustment in the cost of retained earnings for tax and costs of purchasing new securities, the following formula may be adopted: A firm’s Ke (return available to shareholders) is 15%, the average tax rate of shareholders is 40% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. and is accumulated from the capital market. Sources of Finance for a Business. Content Guidelines 2. 100 debenture of a firm can be sold for a net price of Rs. The before-tax cost of such a debt can be calculated as below: A company is proposing to issue a 5-year debenture of Rs. Then, we will study the financial needs of a business. 100 debenture of a firm can be sold for a net price of Rs. Compute the cost of new issue of equity shares. The sources are: 1. This is the money raised from outside the business. The cost of equity is not the out-of-pocket cost of using equity capital as the equity shareholders are not paid dividend at a fixed rate every year. However, tax adjustment in determining the cost of retained earnings is a difficult problem because all shareholders do not fall under the same tax bracket. Compute the after-tax cost of debenture. Business Finance "Key … 4 per share last year. SOURCES OF BUSINESS FINANCE INTRODUCTION This chapter provides an overview of the various sources from where funds can be procured for starting as also for running a business. Hence, dividends are usually paid regularly on preference shares except when there are no profits to pay dividends. 2. The value of kd (yield to maturity) can be found by trial and error method using present value tables. The debenture amount will be amortised equally over its life. Cost of Retained Earnings. 2 per share. Cost of retained earnings can be computed with the help of following formula: D = Expected dividend at the end of the year. The cost of debt is the rate of interest payable on debt. 950 less 4% underwriting commission. Calculate the cost of debt assuming that the corporate rate of tax is 35%. Management, Financial Management, Cost of Capital, Finance, Sources. where, the cost of existing capital is to be calculated: Ke = Earnings per share/Market Price per share. Calculate before-tax and after-tax cost of debt assuming a tax rate of 50%. It works like this. It is issued for a long periods of time. Usually, the debt is issued to be redeemed after a certain period during the life time of a firm. – Financial assets. In such a case, principal amount is repaid each period instead of a lump sum at maturity and hence cash outflows each period include interest and principal. The tax rate applicable to the company is 50%. 1. Business Finance It refers to capital funds and credit funds invested in the business. They are classified based on time period, ownership and control, and their source of generation. If a firm wants to compute the current cost of its existing debt, the current market yield of the debt should be taken into consideration. The coupon rate of interest is 14 per cent per annum, and the debenture will be redeemed at 5 per cent premium on maturity. These sources of funds are used in different situations. External Sources of Finance. Further, when debt is used as a source of finance, the firm saves a considerable amount in payment of tax as interest is allowed as a deductible expense in computation of tax. 7 The cost of the source of finance. Hire purchase: It involves purchasing an asset paying for it over a period of time. iii. The investor’s market expects a growth rate of 5 per cent per year. Study notes. 100 each. The available sources of finance must be ranked according to their capital cost; It is best to go with the choice of finance that the business can afford; To access more topics go to the O Level Business Notes page. It includes The business has to pay an interest on the borrowing. The business does not need to purchase the asset. 95.90. Organizational Behavior F. Luthans, B.C. A company issues 1,000 7% Preference Shares of Rs. These are well covered in manuals and textbooks. CONCEPT OF BUSINESS FINANCE: The term finance means money or fund. The cost of preference capital which is perpetual can be calculated as: Further, if preference shares are issued at Premium or Discount or when costs of floatation are incurred to issue preference shares, the nominal or par value of preference share capital has to be adjusted to find out the net proceeds from the issue of preference shares. Lecture Notes for Finance 1 (and More). Compute the cost of debt capital. Issue of share: It is a permanent source of finance but only available to limited companies. The coupon rate of interest is 14 per cent per annum, and the debenture will be redeemed at 5 per cent premium on maturity. External sources of finance include the following: Sell of shares/Owner’s own capital. The financing can happen at any stage of a business’s development. Click on these links to know more about debt factoring, Factoring of debts Advantages and Disadvantages of debt factoring. X Ltd. has issued redeemable zero coupon bonds of Rs. Leasing: Leasing involves using an asset, but the ownership does not pass to the user. The business thus can use the asset without purchasing it and can use the revenue earned from its sale for other purposes. Permanent source of capital. • Two objectives of business: – Grow wealth. To remove this drawback, realised yield method, which takes into account the actual average rate of return realised in the past, may be applied to compute the cost of equity share capital. A company issues 10,000 10% Preference Shares of Rs. It dividends of a firm are expected to grow at a supernormal growth rate during the periods when it is experiencing very high demand for its products and then, the dividends grow at a normal rate when the demand reaches the normal level, the constant growth equation [P0 (or MP) = D0 (1+g)/Ke – g] can be suitably modified to calculate the cost of equity. Usually the maintenance of the asset is done by the leasing firm. Whenever a company wants to raise additional funds by the issue of new equity shares, the expectations of the shareholders have to evaluate. The company pays a dividend of Rs. Excel Ltd. has issued 5000 10% Debentures of Rs. Debentures are generally freely transferrable by the debenture holder. Calculate cost of preference capital if these shares are issued (a) at par, (b) at a premium of 10%, and (c) at a discount of 5%.
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