Managerial and Financial Analysis Chapter 10: Sources of Finance

Sources of finance

A company uses two sources to raise funds

1. Equity source
2. Debt source

1. Equity Financing

1.1. Equity

Equity typically refers to ownership in a company. In other words, In the event of a

company liquidation where all of the assets are sold and all debts are paid off, shareholders'
equity, or owners' equity represents the remaining funds available for distribution to the
company's shareholders.

Shareholders’ Equity = Total Assets − Total Liabilities

As an example, below is an extract of ABC Corporation's balance sheet as of September 30,

2018

Total assets Rs. 354,628

Total Liabilities Rs. 157,797
Total equity would be Rs. 196,831

Equity shareholders gain a return on their investment in two ways:

1. Capital Gain
2. Dividend

The cost of equity is higher than other forms of finance as the equity holders carry a high
level of risk, and therefore demand the high returns as compensation

1.2. Types of Equity Stocks

There are two main types of shares, a company issues to raise funds from market

1.2.1. Ordinary Shares

Ordinary shares represent ownership in a company. These shares entitle shareholders to

vote on certain company decisions, receive dividends, and receive residual interests in case
of liquidation of company.

1.2.2. Preference Shares

Shares that entitle shareholders to get fixed dividend, before it is distributed to ordinary
shareholders are called preference shares.

1
Managerial and Financial Analysis Chapter 10: Sources of Finance

Difference between ordinary shares and preference shares

Basis of difference Preference shares Ordinary shares

Dividend rate Fixed
Dividend distribution Receives the dividend before
ordinary shareholders
Liquidation Amount is repaid to
shareholders before ordinary
shareholders
Variable
Paid only if there are spare funds
after the payment of a
preference dividend
Amount is repaid to
shareholders after preference
shareholders

Voting rights Don’t have voting rights Normally receive the right to
vote on major decisions. Each
share has one vote.

1.3. Methods of Floatation

There are five principal methods for a company to raise equity finance

1.3.1. Initial Public Offering (IPO)

An Initial Public Offering (IPO) is the process through which a company offers its shares to
the public for the first time, allowing it to become publicly traded on a stock exchange.

In an IPO, the company sells a portion of its ownership (usually common shares) to investors
in exchange for capital to fund its operations, growth, or other objectives. The shares are
also sold to institutional investors, such as mutual funds, pension funds, and hedge funds, as
well as to individual investors through brokerage firms.

The IPO process involves several steps, including

 The selection of an underwriter to help manage the offering,

 Preparing financial statements and disclosures,
 Registering with the relevant securities regulator, and
 Determining the share price and number of shares to be sold.

IPO is normally the most expensive route to market.

1.3.2. Private placement

Private placement refers to the sale of securities to a limited number of qualified investors,
such as high net worth individuals, institutional investors, or accredited investors, without
the need for a public offering.

2
Managerial and Financial Analysis Chapter 10: Sources of Finance

In a private placement, the issuer of the securities, typically a company seeking capital
negotiates the sale of the securities directly with the investors or through intermediaries,
such as brokerage firms. The terms of the securities, such as the price, dividend rate, are
negotiated between the issuer and the investors and may vary depending on the needs and
objectives of both parties.

A private placement normally results in a narrower shareholder base and potentially lower
liquidity in the shares once the company has been admitted to a market.

Private placements are typically used by companies that are not yet ready for a public
offering or that want to avoid the public scrutiny and disclosure requirements of a public
offering. Private placement is less risky and a low cost method of issuing shares.

1.3.3. Rights issue

A rights issue is an offer made by a company to its existing shareholders to purchase

additional shares of the company at a discounted price. The existing shareholders are given
time frame within which they are required to accept this offer.

The terms of a rights issue are determined by the company and can include details such as
the subscription price, the number of shares offered, and the deadline for accepting the
offer.

1.3.4. Bonus issue

A bonus issue, also called a stock dividend, is when a company issues additional shares to its
existing shareholders, without any payment being required from the shareholders.

Principally in bonus issue, the company allocates additional shares to its shareholders in
proportion to their existing shareholdings, which increases the total number of outstanding
shares.

The purpose of a bonus issue is to reward shareholders by increasing the number of shares
they hold, without changing the proportionate ownership of the company. For example, if a
company issues a bonus issue of one share for every five shares held, a shareholder who
owns 100 shares before the bonus issue will receive 20 additional shares, increasing their
total holdings to 120 shares.

1.3.5. Warrants

A warrant is a derivative security that gives the holder the right, but not the obligation, to
buy or sell a specific underlying asset at a predetermined price and date.

Warrants are typically issued by companies as a way to raise capital. When a company
issues a warrant, it gives investors the opportunity to buy shares of its stock at a specified
price (known as the "strike price") during a specific period of time.

3
Managerial and Financial Analysis Chapter 10: Sources of Finance

For example, if XYZ Corporation issues warrants that entitle the holder to purchase one
share of XYZ stock for Rs. 30 per share within the next two years, the warrant holder can
choose to exercise the warrant if the market price of XYZ stock rises above Rs. 30 per share,
enabling them to purchase the shares at a lower price and then sell them at a higher market
price, realizing a profit. If the market price of XYZ stock stays below Rs. 30, the warrant
holder may choose not to exercise the warrant and let it expire.

Debt Financing

1.4. Debt

Debt refers to borrowings of a company. Company borrows funds for certain time period
and then repays along with interest

1.5. Categories of Debt

1.5.1. Long and Short Term Debt

Long-term debt refers to any debt that is scheduled to be repaid over a period of more than
one year. It typically includes loans, bonds, and other financial instruments that have a
maturity period of five years or more. Long-term debt is usually used to finance major
investments, such as real estate or infrastructure projects.

Short-term debt, on the other hand, is any debt that is scheduled to be repaid within one
year. It typically includes credit cards, lines of credit, and other types of revolving credit
facilities that are used for day-to-day operations or to finance short-term needs, such as
inventory or accounts receivable.

1.5.2. Redeemable and Irredeemable Debt

Redeemable debt is a type of debt that is required to be repaid by the borrower to the
lender. Redeemable debt can be either long-term or short-term and can include bonds,
loans, and other financial instruments.

Irredeemable debt is also known as perpetual debt or perpetual bonds, and it is a type of
debt that has no maturity or repayment date, and the borrower only needs to make
periodic interest payments to the lender. The principal amount of the debt remains
outstanding indefinitely, and the borrower has no obligation to repay it.

1.6. Forms of Debt

1.6.1. Bond

A bond is a type of debt security that allows an investor to lend money to a borrower,
usually a corporation or government entity. These bonds are issued by various
organizations, including municipalities, states, and companies, to fund projects and

4
Managerial and Financial Analysis Chapter 10: Sources of Finance

operations. When an investor buys a bond, they receive a bond certificate that outlines the
terms of the loan, including the par value, coupon rate, date of redemption, and terms and
conditions.

Bond may be of different types. These are:

o Deep discounted bonds

A deep discount bond is a type of bond that is sold at a significant discount to its face value.
This means that the investor pays a lower price to buy the bond than the amount that will
be paid out when the bond matures. The bond pays interest during its life, which is
generally lower than the coupon rate of a regular bond.

For example a company issues 10 years, 5% bond with face value of Rs. 1000 against Rs.
600.

o Zero coupon bond

A zero coupon bond is a type of bond that is issued at a discount to its face value and does
not pay any periodic interest payments. Instead, the investor profits by buying the bond at
a discounted price and receiving the full face value of the bond at maturity.

For example, a company issues a bond with a face value of Rs. 1000 against Rs. 450. The
bond has life of 10 years. This means the investor pays Rs. 450 to buy the bond and gets full
face value i.e. Rs. 1000 at maturity. The bond does not pay interest during life.

o Euro bond

A euro bond is a debt security issued in a currency other than the currency of the country or
market where it is issued. For example, a Canadian company issues a bond denominated in
US Dollar in Pakistan. Instead of issuing a bond denominated in Pak Rupee, it decides to
issue a (euro) bond denominated in US dollars.

5
Managerial and Financial Analysis Chapter 10: Sources of Finance

o Convertible Bond

A convertible bond is a type of bond that can be converted into a predetermined number of
shares of the issuing company's common stock at the bondholder's discretion. This means
that the bondholder has the option to convert their bond into equity, effectively becoming a
shareholder in the company.

The bond may have certain restrictions or conditions, such as a specific time period during
which the bond can be converted, a minimum or maximum conversion price.

Once bond is converted into equity shares, it then cannot be converted back into original
fixed return security.

2.3.2. Loan Note or Loan Stock

A loan note is a legal document that represents a debt obligation between a borrower and a
lender. It is a type of promissory note that specifies the terms and conditions of a loan,
including the principal amount borrowed the interest rate, the repayment schedule, and any
other relevant details. A loan note can be drawn up by either borrower or lender, though it
is more traditionally completed by the lender. The note is considered valid until the amount
listed on the document is paid in full by the borrower. Loan note is also known as loan stock.

1.6.3. Debenture

Debentures are long-term debt instruments that are typically issued by companies and
governments to raise capital for financing various projects and investments. Debentures are
unsecured bonds, meaning that they are not backed by any collateral and the issuer relies
solely on its creditworthiness for repayment. Debentures typically have a maturity of more
than 5 years.

1.6.4. Commercial Papers

6
Managerial and Financial Analysis Chapter 10: Sources of Finance

Commercial papers are short-term debt instruments that are typically issued by companies
to meet their short-term funding needs. Commercial papers are unsecured promissory
notes with a maturity of usually less than 1 year. Commercial papers are usually sold in the
money market and are highly liquid.

1.6.5. Bank Loan

Bank loan is a type of debt financing provided by a financial institution, such as a bank, to an
individual, business, or organization. Bank loans are a common way for individuals and
companies to access funds for a variety of purposes, such as purchasing a home or car,
financing a business venture, or covering unexpected expenses.

Bank loans can be either secured or unsecured. Secured loans require the borrower to put
up collateral, such as a house or car, as a guarantee that the loan will be repaid. Unsecured
loans do not require collateral, but may have higher interest rates to compensate for the
increased risk to the lender.

A bank loan provides clarity to both the borrower and the bank regarding the amount
repayable to bank and the timing of interest payments. This makes budgeting and financial
planning easier for the borrower.

Features of bank loan include

 Interest is tax deductible

 Bank loan makes planning and budgeting easy because re-payments are predetermined.
 It can be taken in foreign currency
 Bank loan is usually secured
 Short term loan is suitable to fund working capital needs
 Long term loans are suitable for long term investments like investment in PPE.

2.3.6. Bank Overdraft

A bank overdraft is a financial arrangement in which a bank allows a customer to withdraw

more money from their account than they currently have available, up to a predetermined
limit. Essentially, an overdraft is a short-term loan that is used to finance day-to-day
operational requirements of organization.

When a customer overdraws their account, they are essentially borrowing money from the
bank, and they will be charged interest on the amount of the overdraft until it is repaid.
Overdraft fees may also apply, which are charges levied by the bank for the use of the
overdraft facility.

The terms of an overdraft, including the interest rate and fees, are typically outlined in an
agreement between the customer and the bank

7
Managerial and Financial Analysis Chapter 10: Sources of Finance

Other features of bank overdraft

 Interest and fees are tax deductible.

 Interest is only paid when the account is overdrawn.
 Penalties for breaching overdraft limits can be severe

1.6.7. Treasury Bill (T-Bill)

A Treasury bill (T-bill) is a short-term debt security issued by the government to raise funds.
T-bills are typically issued with maturities of less than one year, ranging from a few days to
up to 52 weeks.

T-bills are considered to be a very safe investment because they are backed by the full faith
and credit of the government. They are also highly liquid, meaning they can be easily
bought and sold in the secondary market.

1.7. Terminologies related to Debt Instruments

1.7.1. Par Value

Par value (also known as stated value, face value or nominal value) indicates the amount of
debt that the company owes to the holder of the instrument.

1.7.2. Market Value

The market value of a debt instrument is the price at which it can be bought or sold in the
financial market at any given time. Par value of debt instrument remains fixed throughout
the life of the instrument, but the market value can fluctuate based on various factors such
as changes in interest rates, credit ratings, and overall market conditions.

1.7.3. Charge (Mortgage) on Debt

A debt may be secured through a fixed or floating charge on assets.

A fixed charge is a specific type of security interest that a lender may take over a borrower's
assets as collateral to secure a debt obligation. The lender has a specific, identified claim on
a particular asset of the borrower. When a fixed charge is created over an asset or group of
assets, the borrower cannot dispose of or use those assets without the lender's consent.

For example, if a company borrows money to buy a piece of equipment, the lender may
require a fixed charge on that equipment to secure the loan. This means that if the company
defaults on the loan, the lender has the right to seize and sell the equipment to recover the
outstanding debt.

Another example could be a fixed charge over a piece of real estate; the borrower cannot
sell or mortgage that property without the lender's consent.

8
Managerial and Financial Analysis Chapter 10: Sources of Finance

A floating charge is a type of security interest or lien that a lender may place on a group of
assets, such as inventory, accounts receivable, or other assets that are subject to change
over time. Unlike a fixed charge, a floating charge does not attach to specific, identifiable
assets at the time it is created. Instead, it "floats" over a group of assets that may change
over time.

When a specific event occurs, such as a default or insolvency, the floating charge
"crystallizes" into a fixed charge over specific assets, providing the lender with a more
specific and secure claim to those assets.

A fixed charge is considered more secure form of collateralization.

Criteria Fixed Charge Floating Charge

Assets Specific, identifiable assets Group of assets subject to change
Identification Assets are identified at the time Assets are identified at the time of
of the charge crystallization

Flexibility Less flexible, as borrower cannot More flexible, as borrower can use
dispose of or use assets without assets in the normal course of business
lender's consent

Example Fixed charge over real estate, Floating charge over inventory,
machinery or equipment accounts receivable

1.7.4. Interest Rate

Interest is calculated on par value. Usually the interest rate is fixed. However, it may also be
floating (variable). A fixed interest rate is a type of interest rate that remains the same
throughout the entire term of the loan. A floating interest rate, also known as a variable
interest rate, is an interest rate that is not fixed and changes over time.

2. Islamic Financing

Islamic financing, also known as Sharia-compliant financing, refers to process of raising

capital based on the principles of Islamic law, or Sharia.

Modes of Islamic Finance include

2.1. Murabaha

Murabaha is a form of sale transaction. In Murabaha arrangement, the purchase price,

selling price and the profit margin are clearly known to each party at the very inception of
transaction. Payment in murabaha transaction is either in installments or in lump sum after

9
Managerial and Financial Analysis Chapter 10: Sources of Finance

a certain period of time. Murabaha arrangement is used as a mode of interest-free financing

to fund the purchase of consumer items, capital goods, real estate, raw material.

Features of Murabaha

o The subject (underlying asset) of murabaha must

 Exist at the time of sale

 Be in ownership of seller at the time of sale
 Be available in physical
 Have something of value
 Not be a forbidden commodity

o The murabaha must be unambiguous. his means that both parties must agree on the
terms of the sale transaction, including the purchase price, selling price, profit margin,
and payment schedule, without any room for negotiation or renegotiation after the
agreement is made.

2.2. Musharakah

Musharakah is a partnership structure in Islamic financing wherein the partners share in the
profits and losses of enterprise or partnership.

Musharakah plays a vital role in financing business operations based on Islamic principles.
For example, Mr. A wants to start a business but has limited funds. Mr. B has excess funds
and wishes to be the financier of a commercial project. Mr. A and B meet with each other
and agree to finance a project and share in profit or loss from business. This arrangement is
called Musharakah. Note that the arrangement fulfilled the financing needs of Mr. A in
Islamic way – the partnership. Profits are divided between partners in predetermined ratios.

2.3. Mudarabah

Mudarabah is an Islamic contract wherein one party supplies the money and the other
provides management in order to do a specific trade / business. The party supplying the
capital is called owner of the capital or ‘RAAB-UL-MAAL’. The other party is referred to as

10
Managerial and Financial Analysis Chapter 10: Sources of Finance

‘MUDARIB’ who actually runs the business. In the Islamic jurisprudence, different duties and
responsibilities have been assigned to each of these two.

The proportionate share in profit is determined by mutual agreement. But the loss, if any, is
borne only by the owner of the capital, in which case the entrepreneur gets nothing for his
labor.

There are two different types of mudarabah

2.3.1. Restrictive Mudarabah

Type of mudarabah wherein the investor has specified investment details in the mudaraba
contract and has restricted the working partner within the scope of such specifications

2.3.2. Unrestrictive Mudarabah

The type of mudarabah wherein the investor has granted the working partner the right to
undertake any lawful investment to make profits is called unrestrictive mudarabah. It is the
responsibility of the working partner to avoid unlawful and high-risk investments. The
working partner is liable for any losses suffered from such investments

2.4. Ijarah

Ijarah refers to a contract wherein a lessor transfers the usufruct (the right to use) of an
asset to a lessee for a specified period, for an agreed payment or a series of payments.
Ijarah is often called 'islamic leasing'.

Rules or Features of Ijarah

o The lessor must own the asset being leased for the entire period of the lease.

 No interest would be charged if the lessee delays or defaults on payment

 Use of the asset being leased must be specified in the contract.
 The lessor must agree to bear all liabilities emerging from ownership of asset e.g.
 Normal wear and tear of asset
 Obligation to insure the asset

11
Managerial and Financial Analysis Chapter 10: Sources of Finance

o The lessee must agree to bear operational expenses related to use of asset e.g.

 Overheads related to running of an asset

 Any damage to asset arising out of lessee’s negligence

4. Lease

Lease refers to a contract wherein a lessor transfers the usufruct (the right to use) of an
asset to a lessee for a specified period, for an agreed payment or a series of payments

There are two types of lease

4.1. Finance Lease

Finance Lease is also called Capital Lease or Sale Lease. In finance lease,
o Lease period covers substantial period of asset’s economic life
o The lessor retains ownership rights of asset
o Risks and rewards related to asset are transferred to lessee
o Legal ownership of asset is transferred to lessee at the end of lease term

According to IFRS-16 finance lease is capitalized in the books of accounts. Finance lease
affects capital ratios like ROCE

4.2. Operating Lease

An operating lease is a lease other than a finance lease.

4.3. Difference between finance and operating lease

Basis of difference Finance Lease Operating Lease

Lease Term Very Long Short
Risk and reward Transferred to lessee Not transferred to lessee
Insurance Responsibility of lessee Responsible of lessor
Maintenance Responsibility of lessee Responsible of lessor
Ownership Lessor gives lessee an option to There is no bargain purchase
buy asset at price lower than the option in operating lease
market price (bargain purchase
option)

5. Other Sources of Finance

5.1. Business Angles

12
Managerial and Financial Analysis Chapter 10: Sources of Finance

Business angels are generally wealthy, entrepreneurial individuals who provide capital in
return for a proportion of company’s shares. Angels normally don’t get involved in
management of project or company operations

5.2. Venture Capital Fund

Venture capital fund is a pool of funds that seeks private equity stakes in startups and SMEs
with strong growth potential. These investments are generally characterized as very high-
risk/high-return opportunities.

5.3. Private Equity (PE) Fund

PE fund is a limited liability partnership of PE firm and accredited investors. These

accredited investors – large institutional investors and high net worth individuals – provide
large sums of money, for extended period of time, to buy stakes in private companies or
acquires control of public companies with plans to make them private.

5.4. Asset Securitization

Asset securitization is a process of converting existing illiquid assets or future cash flows into
marketable securities. The process helps financial institutions to raise capital.

Simple example

For example, a bank bundles its home loans together into a single package, which it then
sells to a Special Purpose Vehicle (SPV). This SPV creates mortgage-backed securities and
sells them to investors as bonds. The amount collected by SPV is paid to bank. The bank uses
this money to fund new loans/projects. The investors of mortgage backed securities (bonds)
receive interest and principal payments from the underlying loans.

Numerical example

Suppose a bank has Rs. 10 million worth of mortgages (i.e., loans for buying homes) that it
has issued to customers. The bank wants to free up some of the capital it has tied up in
these mortgages, so it decides to securitize them.

The bank sets up a special purpose vehicle (SPV), which is a separate legal entity that will
buy the mortgages from the bank. The SPV then issues securities (e.g., bonds) that are
backed by the mortgages. For simplicity, let's say that the SPV issues Rs. 10 million worth of
bonds that pay a fixed annual interest rate of 5%. The bonds are backed by the Rs. 10 million
worth of mortgages that the SPV purchased from the bank.

Investors who buy these bonds will receive interest payments of Rs. 500,000 per year (i.e.,
5% of Rs. 10 million) for a fixed period of time. These payments are funded by the interest
and principal payments that the homeowners make on their mortgages.

13
Managerial and Financial Analysis Chapter 10: Sources of Finance

In this way, the bank has converted illiquid mortgages into tradable securities that can be
sold to investors. The investors get a fixed income stream from the interest payments on
the bonds, and the bank has freed up capital that it can use for other purposes.

6. Direct and Indirect Investments

6.1. Direct Investment

Direct investment is the type of investment wherein investor directly invests in a particular
asset e.g. Purchases a real estate, invests in a company share.

In direct investment the investor

 Owns and controls an asset
 Takes responsibility to manage asset
 Enjoys the benefits of asset
 Assumes all risks attached with asset

6.2. Indirect Investment

It is the type of investment wherein the investor does not directly own or invest in an asset,
he invests in an investment vehicle. The investment vehicle is a pool of funds that invests in
various options like shares, bonds, debentures, derivative instruments, and real estate etc.
In indirect investment, the investor.

o Does not directly own an asset

o Does not take responsibility of asset management
o Enjoys a certain portion of profits from asset performance

6.3. Foreign Direct Investment

FDI describes when a company (investor) invests in overseas operations either by buying a
foreign company, or by expanding existing operations overseas.

6.4. Difference between Direct and Indirect Investment

Direct investment Indirect investment

Divisibility The investor is often required to
fund the whole project or asset
e.g. Building and owning an
overseas distribution network.
Thus greater levels of capital are
required.
More opportunity to spread the risk
and share the indirect investment
with other investors. This enables
the investor to invest in more
opportunities each one with a more
modest amount. For example being
part of a syndicate of 20 investors
who invest in 20 different start-up
opportunities through an overseas

14
Managerial and Financial Analysis
Liquidity Normally illiquid due to the size
(larger) and uniqueness of the
investment
Holding Period Potentially longer-term, may be
permanent. For example owning a
factory in a foreign territory.
15
Chapter 10: Sources of Finance
holding company exposes the
investor to 20 opportunities rather
than just one.
More liquid than direct
investments as investment funds
are often open-ended with
investors entering and leaving the
investment vehicle frequently in an
open market.
Medium term. For example
investing in a real estate
investment fund until a price target
has been met.