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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

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5. Case 3 8

6. Case 4 9

7. Conclusion 10

8. Reference and Bibliography 11

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

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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.

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.

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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 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.

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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.

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 1

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The 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 2
Leasing 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 3
If 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 4
The 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.

Case 2:

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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 1
A 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 2
Should 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 3
The 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

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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 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

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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.

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

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• www.bankofengland.co.uk

• www.arrowvale.worcs.sch.uk

• www.business24-7.ae

• www.etihadairways.com

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