HND Business

April – July 2010

Managing Finance

Sources of Finance Assignment 1

(Rashida Yvonne Campbell)

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Contents Page

Page

1. Introduction 3

2. Definitions

Bank loan 3

Overdraft 3

Long term loan 3

Medium term loan 3

Short term loan 3

Interest 3

Retained earnings 4

Organic growth 4

Joint venture 4

Bonds 4

Shares 4

Venture Capitalist 5

Government grants 5

Sponsorship 5

3. Case 1 6

4. Case 2 7

5. Case 3 8

6. Case 4 9

7. Conclusion 10

8. Reference and Bibliography 11

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Introduction

This assignment studies the different sources of finance available for various types of

businesses. Firstly it is important to understand the definitions of different types of sources

of finance, the advantages and disadvantages before deciding which one is most suitable

giving reasons to why different sources of finance was chosen for the given case studies.

Types of sources of finance and their definitions

The time periods given below are approximate. It is important to note that each lending

organization will specify the exact number of years the loan duration will be for each

category of short, medium and long term.

Bank Loans – are in the form of medium to long term loans (5 years or more) and will often

be for large amounts of money for starting up a business or to expand. Businesses will

agree with the bank to pay a monthly installment with fees and interest charges. Banks

usually require some form of security against the loan. The interest rate charged maybe

fixed or variable. Businesses can request for fixed interest rates (or shop around to find the

best deal) this will provide an easier repayment schedule and businesses can plan and

manage their finances better if the rate is fixed.

Bank Overdraft – is a short-term loan and could be repayable within one month and less

than 12 months. Interest rates are usually high and incur extra fees such as administration

costs. Overdrafts are flexible as the amounts can vary and an overdraft is simple to arrange.

Long term Loan – is a loan which is often used for a large sum of money and usually the

payment period is more than 5 years and up to 30years. This type of loan is used for

starting up new businesses, expansion and/or buying new fixed assets for the business.

Loans are usually paid on monthly installments with possible agreed fixed interest charge.

But variable interest rates may also be applied. Also the borrower may be required toward

contributing a small percentage of the total loan such as 1 – 5%.

Medium term Loan – is a loan of a medium amount repayable in installments within 5years

with agreed interest rates. This type of loan is suitable for furnishings, vehicles, equipment,

interior décor etc.

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Short term loan – is a loan that is for a small amount re-payable within the period of one to

five years (1-5 yrs), plus agreed interest charge. An example for this type of loans’ usage is

for purchasing cars, stocks for inventory, initial start up costs such as registration fees.

Trade credit – another form of short term loans for products and services, where suppliers

offer an advantage of paying bills instead of one month but a period or up to 90 days (3

months) to their customers. This is beneficial for businesses since there are no interest

charges, but penalties should they further delay payment.

Interest – Banks provide services by lending money in the form of overdrafts and loans and

bank will charge for this service. The extra charge is called interest, these are the profits

made. The Bank of England sets an interest rate at which it lends to financial institutions. This

interest rate then affects the whole range of interest rates set by commercial banks, building

societies and other institutions for their own savers and borrowers. It also tends to affect the price of

financial assets, such as bonds and shares, and the exchange rate, which affect consumer and

business demand in a variety of ways. Lowering or raising interest rates affects spending in the

economy. (Source form www.bankofengland.co.uk)

Internal sources of finance - Retained earnings – also called “Organic growth” growth

generated through the development and expansion of the business, these are profits made

by the company. These can be achieved through:

Generating increased sales – increasing revenue to impact on overall profit level

Used to retained profit and used to reinvest into the business.

Joint Venture – two or more parities join together to start up a business; hoping it will grow

and make a profit. The joined parties will share revenue, expenses and control of the

business. The percentage or ownership is not necessarily 50/50. But usually depends on the

amount of capital one invests. E.g. A business needs £100,000, so person A invests £80,000,

Person B invests £20,000. Therefore Person ‘A’ Owes 80% of the business and Person ‘B’

owes 20%. This is the case for votes and profits in the form of dividends.

Issuing Bonds – the time period may vary and can be specified according to the needs of the

business short, medium or long term. It raises finance quickly with fixed interest rates

payable to creditors (bond holders) whether the business makes a profit or not. The interest

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rate is usually higher than banks to attract investors. Depending on the amount of finance

needed will determine the time period and how many bonds the business will issue.

Issuing Shares – when a business offers shares for sale, the purchaser of these shares is

known as the shareholder who owns part of the limited company (PLC). The shareholder

becomes a member of it and has rights to attend the annual general meeting. Shares are

associated with medium to long term investment; therefore the capital received from share

issues can be used for the core of the business or expansion into new ventures.

Venture Capitalist – there are some organizations that exist (especially in the UK, US etc)

that specialize in providing venture capital to small and medium sized businesses. It is

regarded as a high risk investment. “It is not unusual for sums in excess of £750,000 to be

raised in this way.” (Vocational Business Planning, 2nd Edition, Collins, pg 343). Venture

capitalists provide packaged loans in return for purchase of shares.

Government Grants and incentives - in the UK under the ‘New Labour’ Gordon Brown set-

up the Enterprise Association to give funds/grants/aid, professional business advice as well

as legal help. The financial funds are primarily available for new start up businesses rather

than existing ones. The funds issued are small amounts and would not cover all necessary

business costs. The business would also have to meet set criteria and be eligible in order to

receive such funding. However this source is useful for start up businesses and non–profit

making organizations since the funds are NOT repayable. This source of finance is time

consuming with many bureaucratic forms and applications.

Sponsorship – an existing business provides funds for an organization that is either profit or

non-profit making such as sports, television programs etc. In return the creditor/investor

receives exposure to a target audience. This form of raising finance is popular amongst sport

teams/clubs.

Leasing - a specified time for renting buildings and equipment, a rental fee is paid to the

owner in return for use of the asset. This is a medium term source of finance 2-4 years, and

then the contract needs renewal.

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Case 1:

A medium-sized engineering firm with an annual return of over £ 2.5 million has decided to install a new piece of machinery to help improve its productivity. The equipment needs to be housed in a new building to be constructed on the site. The forecast of the building is £ 150,000 and the equipment £400,000.

Option 1The appropriate source of finance for this case would be to take 50% from the retained earnings and reinvest this together with 50% from a bank loan. This approach will reduce the number of years to pay back the installments and will result in less amount of interest to pay from the amount borrowed. It would more attractive to the bank lender to issue a loan when a business has also provided some capital towards the new venture.

Option 2Leasing the equipment from an owner would save the business from raising £400,000 and the owner would be responsible for the maintenance and renewal of the equipment since the rental charges are high. The business would need to renew the rental contract after a number of years usually between 2-4 years. The drawback of leasing is that the owner is likely to increase the cost of rent after the end of the contract. The main benefit to leasing is that the business avoids large cash outflows when buying new assets. The finance for the remaining £150,000 can be raised from retained profits or a medium to long term bank loan providing the repayments are considerably lower than the profits generated from the business activities of this building. The £150,000 should be paid in installments with fixed interest rates to provide for better planning and forecasting of the business.

Option 3If we assume the business to be a private firm then another method of raising finance is for the firm to open up invitations to new partners based on the condition that the new partner can bring in the capital required for the building and equipment. If the company already has existing partners it could be an alternative that the partners raise the finance either individually or shared using their own savings and/or borrow from a long-term loan with fixed interest rates. Providing the payment made in installments is at a reasonable cost so that the business is still making sufficient profit. Showing evidence of this turnover of £2.5 million would secure a long-term loan. Bearing in mind that the business has existing assets, profit and the new building and equipment will also generate new future profits as well as the building increasing in value over a period of time.

Option 4The business is operating as a private firm therefore there is a possibility for the company to move over to a PLC and issue shares to raise the necessary finance. However this would involve lengthy legal procedures and will take time to set up. Plus the risk that investors in shareholding may not be in demand for new companies, people are reluctant to buy shares in such businesses due to the risk factor.

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Case 2:

An individual has been made redundant after 20 years with a major organization and has received a lump sum redundancy payment of £70,000. The individual is planning to setup bookmakers and has identified suitable premises valued at £180,000 near to a major town centre shopping precincts.

Option 1A joint venture will be ideal for this case, as the individual has a capital sum of £70,000 and another partner will put in the remaining capital (£110,000) and will be able to borrow a long-term loan from the bank. The advantage for joint venture is that the risk is spread, advice will be bought in through experience and the company will be able to bring expertise for higher growth for a long term basis. And the disadvantage for this is that profits will be shared with a shareholder investor.On the other hand the disadvantage of the bank loan will be that the bank may not be able to provide a loan due to the redundancy; unless the owner provides a good business strategy plan which will forecast to give a good return and proves the ownership of some assets or security i.e. Property, land etc.

Option 2Should the owner wish to remain the sole owner then option 1 is not feasible. A better solution would be:

£70,000 redundancy payment should be used for working capital, interior fittings/furniture/equipment/inventory or for registration and license fees.

£180,000 needs to be raised for long-term investment similar to that of mortgages; it requires a long term loan from a bank or other financial lending organizations. The loan should be payable in installments with the interest rate fixed at a much lower rate than the predicted profit to be made (return on investment). A point to note here is that the premises will also increase in value over a period of time and can be sold should the business not succeed. The property can be used as a security against the loan.

Option 3The future owner of the bookmaker should proceed with option 2 but in addition aim to raise some of the capital needed from government grants and incentives. Since this takes time the owner can proceed with his business plan using the finance provided by the bank/finance company and should he receive a grant from the government it can be used to pay off a lump sum of the loan reducing the overall amount outstanding.

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Case 3:

A large plc is planning on moving a major part of its production facility to Cornwall. It has

identified a site near a former chalk pit that is now not used. The estimated cost of the

facility is £4.5 million.

Option 1

A long term bank loan will be suitable to for a large company planning to move as the

estimated cost is £4.5 million and share issue will also be ideal as this can raise capital that

can be used for the move, this is a long term source of finance. Shareholders will have to

share the control of business, each share gives the shareholder a vote on the direction of

the company and will spread the risk to the number of shareholders, and this will also

reduce the amount of loan to borrow from the bank which will also result to fewer

installments and less interest to pay.

Option 2

The PLC can also issue bonds because this raises capital quickly without the company having

to pay back immediately, they will have a specified time period of when the bond reaches

maturity. It is usually a long-term investment from the creditor’s perspective. For a company

that has an already established PLC potential bond holders will be satisfied that the

company is trustworthy and will make sufficient profit to pay the interest on the bonds. The

company should try to obtain as much as possible finance through the issue of bonds as long

as it can benefit from the leverage. Therefore shares are one option but bonds are a better

choice.

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Case 4:

A rugby club is anticipating turning fully professional after the team secured promotion to the Zurich premiership. To take this place in league, the league committees have insisted that it also improves facilities at the ground. It has been estimated that the cost of these two measures will be £500,000.

Option 1

The best way to inject a source of finance in a rugby club is through finding a sponsor. A sponsor will bring money into the club and raise funds to enable the club to improve its facilities.

Advantages of having a sponsor are

The marketer can reach different target of audiences The sponsors’ logo could appear on the shirts of the players, logo on the playing field

etc. This gives different advertising that will encourage and promote increase in

participation Sponsors can get many benefits Different advertising will encourage and promote increase in participation

Disadvantages are:

If sponsors withdraw, the club may not be able to carry on Sports loss identity dictated by sponsors Less successful performers may not receive any sponsorship Bad product may damage reputation on sport

(Source from: www.arrowvale.worcs.sch.uk)

Example:

Etihad Airways sponsors Manchester City FC, The Abu Dhabi based airline of the United Arab

Emirates, has become official shirt sponsor of English Premier league side Manchester City

in a three year deal. (Source from: www.business24-7.ae)

Option 2

This organization is a club not a firm; therefore it cannot raise capital via long-term bank

loans, shares, bonds, venture capitalist or partners. The club may not be famous and would

not therefore seek interest from sponsorship. Clubs can also make some financial gains from

licensing providing they are famous enough and have a strong brand name such as

Manchester United, Chelsea, Arsenal etc, there logo is licensed out to sports clothes

manufactures and sport equipment manufacturers. Finance is also raised through selling

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tickets to see matches charging relatively high prices for entrance fees. For case 4, the club

must seek other measures to raise finance. Since sports clubs rely on fans for finance they

would benefit from creating a ‘Special Subscription Fee’ from loyal members giving them

premier privileges but at a premium price for the annual subscription. This method is ideal

as it raises funds rather than relying on loans that must be paid back. A membership

subscription raised finance quickly without the need for the club to justify where the capital

will be invested. Plus the members will feel privileged and continue to remain loyal to the

club.

Conclusion

To conclude the sources of finance are varied, they include internal, external sources of

finance that are either payable with interest, sharing of profits/company and in the form of

dividends. Other sources include the raising of funds that are not necessarily payable and

are available in the form of government funds, aids, donations, sponsorships, memberships,

selling of tickets, entrance fees etc. There are many types of finance sources that can be

used at any one particular time. Depending on the type of company and trying to get the

best possible finance deal to save the borrower on the risk of borrowing high amounts and

also to pay high amounts on the interest rate. The above cases are similar in the sense that

they all require long-term forms of finance for their business needs. It is important to assess

and match the time period of the investment to the loan or funds raised such as long-term

investment requires long-term loans, the same applies for medium-term and short-term

requirements. The business has to shop around for the best deals and decide on the

combination of the available sources required for their business bearing in mind the type of

ownership the business wishes to maintain. From a creditors perspective the incentive to

invest capital will depend on the level of risk and return on investment together with the

time period.

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Reference and Bibliography

Vocational Business Planning, 2nd Edition, M Glew, M Watts, M Surridge, S Merrills Collins publishers

Complete A-Z Business Studies Handbook, David Lines, I Marcouse, B Martin, 5th Edition, Hodder Education publisher

Business Essentials Course book, Managing Financial Resources and Decisions, 1st Edition, BPP Learning Media publisher

Websites

www.bankofengland.co.uk

www.arrowvale.worcs.sch.uk

www.business24-7.ae

www.etihadairways.com

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