Friday 8 November 2013

42 Sources of finance for a large business

10/10 Key Terms - Internal & external sources of finance

  1. Retained profit - profit kept in the business after tax and dividends have been paid
  2. Assets - something that a business owns that can be used to generate sales revenue, typical examples include buildings, equipment, vehicles etc 
  3. Sale and leaseback - selling an asset such as buildings or IT to a lease company and paying an annual leasing charge so that the asset can still be used.
  4. Bank loan - a sum of money given by a bank to a business.  This is repaid in the short or medium term in installments each month with interest.
  5. Mortgage - external long term finance often 25 years used to buy property such as a factory or office space. The loan is secured against the purchase which is used as a guarantee.  If the loan is not repaid then the lender will take control of the asset.  
  6. Share capital - a share issue will allow finance to be raised which incurs no interest costs.  Share capital does not have to be repaid but the cash it releases will pay for long term expansion
  7. Venture capital  - Money put in to a new business by an entrepreneur willing to take a risk on the business venture i.e. Dragons Den 
  8. Factoring - this is a service where companies who have sold goods on credit sell the debt to a factoring company who pay 90% for the debt and make the other 10% for their efforts in chasing up the outstanding money.
  9. Collateral -  an asset that a bank holds as security for the repayment of a loan 
  10. Government grants - Funds that are made available to develop enterprise zones and start up business in areas of high unemployment.  These funds have to be applied for but do not have to be repaid.

In the news in autumn 2008 many large businesses found themselves under pressure due to falling order books as growth in the economy slowed. Some big businesses especially banks and other financial institutions found themselves in very deep trouble and short of funds.  They therefore took a traditional route to raising funds and asked their shareholders for more money. Halifax Bank of Scotland (HBOS) asked its investors for a further £4 billion.  Raising funds in this way is called a 'rights' issue.  This is because existing shareholders are given the right to buy the new shares.  As the price of the existing shares fell to less than the half price promotional share offer not many people bought the new shares on offer.  See here for more information on the rights issue. 

More sources of finance some sources of finance are from  within the business these are called internal sources of finance and some are external or from outside the business.

External sources of finance 
  • SHARE CAPITAL a business that changes its ownership from a partnership or private ltd company to a public limited company does so in order to raise finance.  This is called 'FLOATING' a company. After its been floated to raise more money it can issue new shares.  These can be offered for sale to everyone or just to its existing shareholders.  If a business decides to sell extra shares investors run the risk of loosing their investment if things do not go well. For the business it means that there are more people or organisations with an interest in the company so existing owners or investors could loose some of their power.
  • Venture capital.  Some entrepreneurs are happy to take a risk with a new business so will provide investment.  In return they are probably wanting to take a share in running the business and a share of its profits should it make any. Such investments are usually high risk businesses i.e. high or new technology developments.  The business gets the cash and the skills, knowledge and experience and business connections.  The investment is not a loan and so it does not carry interest. 
  • Loans. Banks and other financial institutions may agree to lend money to a business.  They will want to ensure that the money will be repaid and will ask for some sort of SECURITY.  This could be the assets of the business such as the land, factory, equipment.  They may also want a say in the management of the business.  The government provides a loan guarantee scheme through the Department of Trade and Industry.  Loans may be SHORT, MEDIUM or LONG term and have fixed or variable interest rates. Loans can be costly and banks can demand them back if they feel that the risk is too great.
  • Leasing. A business can 'RENT' ASSETS such as machinery and vehicles through a leasing arrangement. The business pays a fixed amount of money per year to hire the assets so gains the use of them without having to pay out for the capital expense.
Internal sources these include: 
  • Retained profit. Profit can either be shared among the shareholders or retained within the company.  Profits that are shared are called DISTRIBUTED profits and they are usually shared in the form of a DIVIDEND.  This means that the profit is divided up between the number of shares and each share receives an equal part of it. The profit kept by the company is called UNDISTRIBUTED or RETAINED profit.  The main advantage for the business is that the money is not borrowed and so no interest is payable on it.  The main disadvantage is that SHAREHOLDERS don't receive high dividends.   
  • Selling unwanted assets  If a business has ASSETS (something it owns) that it no longer needs, then it can sell it.  If a business moves into different markets it may no longer need it i.e. a food manufacturer making frozen food may move into fresh food and not need the freezing equipment or food mixers. 
    Group activity Use the link here to find out all you can about rights issues. Put together an information leaflet or web page to explain rights issues to someone who has no idea what they are.  Remember you will need to explain all the technical terms that you use as well!

    Discussion Once a business has shareholders, it is possible for the owners to lose some degree of control over the business. Do you think that this is a good or bad thing to happen? What extra benefits do you think that shareholders bring and what problems might they introduce?

    Web-based activity Visit the link here and you can take part in a game that simulates the movement of stocks and shares by letting you buy shares in celebrities rather than companies.  Once you sign up you have £10,000 to spend on 'shares' in celebrities, who's price goes up and down (as with real shares) according to their performance.  The aim is to make money from dividend payments and from buying and selling shares and the game mirrors how a real stock market works. 

    Typical exam questions on sources of finance for a large business
    1. What is a rights issue?
    2. What is an underwriter?
    3. Why are underwriters called underwriters?
    4. Outline the difference between internal and external sources of finance.
    5. Give one reason why a larger business has more choice of finance than a smaller one.
    6. What does it mean to float a business?
    7. What is venture capital?
    8. Who sets the main interest rates to which all others are linked?
    9. Which government department provides business loan guarantees
    10. What is the most important source of internal finance? 
    sources of finance
    financing growth
    sources of finance for startups

    Nine mark question 

    Mantra Ltd
    Mantra Ltd is a private limited company that manufactures sheds, bird tables and other garden furniture.  It has a factory in Amersham and TWO shops in local towns where it sells its products.  However most of the products are sold through other retailers in and around London.  The company has three stakeholders – the three brothers who run the business.  Mantra Ltd has enjoyed rising sales over recent months and its profits have risen steadily.  Last year the profits were £50,000.  Mantra Ltd needs to build an extension to its factory.  It also needs to buy new equipment for the bigger factory.  The cost of the factory extension and the new equipment and the new equipment is estimated to be £190,000.  The shareholders plan to use a bank loan to raise the entire £190k, although collateral will be required.  However the company’s accountant has suggested that teh company sells one of its shops rather than take out a loan.
         1.     Define the term ‘collaterel’                                                                              (2 marks)      
         2.    Describe TWO assets that Mantra Ltd might use as collateral for the bank loan.        
    (4 marks)
         3.    Explain the disadvantage to Mantra Ltd of borrowing £190k from a bank    (9 marks)         
         4.    Mantra Ltd’s accountant has advised the company to raise its funds by selling one of its shops rather than taking out a loan.  Do you agree?  Give reasons for your answer                                                                                 (9 marks)

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