Module 4: Sources And Cost Of Finance Flashcards
What is a company’s capital structure?
Capital structure refers to the way in which an organisation is financed, by a combination of
long-term capital (such as equity capital, bonds and bank loans) and short-term liabilities (such as a
bank overdrafts and trade payables). It refers in particular to:
the balance between equity and debt capital, and
the balance between long-term and short-term finance.
What is the general principle to be followed when choosing finance for an asset or investment?
As a general rule, assets that yield profits over a long period of time should be financed by long-term
funds. In this way, the returns made by the asset will be sufficient to pay either the interest cost of the
loans raised to buy it, or dividends on its equity funding. If, on the other hand, a long-term asset is
financed by short-term funds, the company cannot be certain that when the loan becomes repayable,
it will have enough cash from profits to repay it.
It is usually prudent for a company not to finance all of its short-term assets with short-term liabilities,
but instead to finance short-term assets partly with short-term funding and partly with long-term
funding
What is overdraft?
Where payments from a current account exceed income to the account for a temporary period, the
bank finances the deficit by means of an overdraft. Overdrafts are the most important source of shortterm
finance available to businesses. They can be arranged relatively quickly, and offer a level of
flexibility with regard to the amount borrowed at any time, while interest is only paid when the
account is overdrawn.
What is a term loan?
A term loan is a loan for a fixed amount for a specified period. A term loan is drawn in full at the beginning of the loan period and repaid at a specified time or in
defined instalments. Term loans are offered with a variety of repayment schedules. Often, the interest
and capital repayments are predetermined.
What is trade credit?
Trade credit is one of the main sources of short-term finance for a business. Current assets such as raw
materials may be purchased on credit with payment terms normally varying from between 30 to 90
days. Trade credit therefore represents an interest free short-term loan. In a period of high inflation,
purchasing via trade credit will be very helpful in keeping costs down. However, it is important to take
into account the loss of discounts suppliers offer for early payment.
What are bonds?
Bonds are long-term debt capital raised by a company for which interest is paid, usually half yearly
and at a fixed rate. Holders of bonds are long term creditors of the company.
What are debentures?
The term bonds describes various forms of long-term debt a company may issue, such as loan notes
or debentures, which may be redeemable (paid back at some point in time) or irredeemable (never
paid back but continue to pay interest indefinitely).
What is a deep discount bond?
Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal
value of the notes, and which will be redeemable at par (or above par) when they eventually mature.
What is a venture capital and for what might it be provided?
Venture capital is provided to companies with high growth potential in return for a stake of
equity. It is high risk financing as there is little guarantee this potential will be fulfilled.
A venture capitalist will generally invest in business start-ups, business development,
management buyouts or where an owner wants to realise some or all of their investment.
Why might a company use lease finance?
Leasing and loans are other forms of debt finance.
The decision whether to lease or buy an asset is a financing decision which interacts with
the investment decision to buy the asset. The decision about how to finance the asset
(whether to borrow money in order to buy it, or whether to lease it) is made once the
decision to invest in the asset has been made.
What is the Weighted Average Cost of Capital (WACC)?
The weighted average cost of capital is the average cost of capital to a company
weighted appropriately for debt and equity proportions.
What is Equity finance?
Equity finance refers to the ordinary share capital of the company.
Equity finance can come from three sources:
– retained earnings; The profits earned by a business can be paid out in the form of a dividend or reinvested. If they are
reinvested, shareholders will expect them to generate sufficient returns to increase shareholder
wealth. For most companies, retained earnings are the most important source of equity finance and
would be used before considering a new/rights issue.
– rights issue of shares to existing shareholders; A rights issue is an offer to existing shareholders enabling them to buy more shares, usually at a price
lower than the current market price.
– new share issue; A quoted company can issue more shares to the stock exchange to raise additional equity finance.
