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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
Overdraf 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

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

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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 ofen
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 Overdraf – 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. Overdrafs are flexible as the amounts can vary and an overdraf is simple to arrange.

Long term Loan – is a loan which is ofen 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.

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Interest – Banks provide services by lending money in the form of overdrafs 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
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
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.

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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 afer 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 afer 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:

An individual has been made redundant afer 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,

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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.

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

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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.

Case 4:

A rugby club is anticipating turning fully professional afer 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

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 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
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

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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.

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, 5 th


Edition, Hodder Education publisher

 Business Essentials Course book, Managing Financial Resources and Decisions, 1 st


Edition, BPP Learning Media publisher

Websites

 www.bankofengland.co.uk
 www.arrowvale.worcs.sch.uk
 www.business24-7.ae

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 www.etihadairways.com

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