COST OF CAPITAL

Capital is the term used by firms for funds needed for investment purposes, (not for day
to day operating needs). This capital carries a cost because the investors want a return
on their investment (fixed assets, technology,).

In the capital structure we include common equity, preferred shares, bonds and long-term
debt. Every component of this capital structure has a cost of obtaining it. Every capital
expenditure requires an estimate of the cost of capital, which is used to discount cash
flows to the present values or to serve as accept/reject criteria in the case of IRR.

The capital structure affects both the size and riskiness of the firm’s earnings stream and
also has an impact on the value of the firm. A number of other decisions, including those
related to leasing, working capital policy etc requires estimates of appropriate cost of
capital.

The amount paid for availing and using capital from a particular source is known as cost
of capital. The supplier of the fund expects a fair return on the investments made based
on the market rate. In case of stock/equity if the firm fails to pay a fair return, the value
of stock also goes down.

Thus in operational term, cost of capital refers to the minimum rate of return
which a firm must earn on its investment so that market value of the firm remains
unchanged, if not increases.

Solomon Ezra has defined “Cost of capital as the minimum required rate of earning or
the cut-off rate for capital expenditures”.

According to the Milton H. Spencer, “Cost of capital is the minimum rate of return
which a firm requires as a condition for undertaking an investment”.

Another approach to explain the cost capital may be pure in economic terms. The cost
of capital is the cost of acquiring the funds required to finance the proposed investment
project i.e. borrowing rate expressed in terms of percentage of capital obtained and
used.

Since the capital may be obtained from different sources, the weighted average
cost of capital is computed.

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FACTORS AFFECTING THE COST OF CAPITAL
 General Economic Conditions: Affect interest rates
 Market Conditions: Affect risk premiums
 Operating Decisions (type of business): Affect business risk
 Financial Decisions (capital structure): Affect financial risk
 Amount of Financing: Affect flotation costs and market price of security

IMPORTANCE OF COST OF CAPITAL

The cost of capital constitutes an integral part of investment decisions and provides a
good yardstick to measure the relative worth of investment proposal. Thus, it is the basic
input information in capital expenditure decisions as the cost of capital is used to discount
the future cash inflows.

Each source of capital involves different cost and different risk. The cost of capital plays
an important role in designing the balanced appropriate capital structure. The cost of each
source of capital should carefully be considered and compared with the risk involved in it.
Thus, it forms a basis for making a comparative study of alternative financial resources
and selecting those, which have minimum cost and ensure maximization of stockholders’
wealth.

ASSUMPTIONS
The cost of capital and its determination is based on the following assumptions:-

1. Business Risk is unaffected by accepting new investment proposal: The term

business risk refers to the variability in annual earnings due to change in sales. This
variability is not going to be affected by accepting a new investment proposal.

2. Financial risk is also unaffected: Financial risk refers to the risk on account of pattern
of capital structure. Here we assume that the capital structure would remain constant.

MEASUREMENT OF COST OF CAPITAL

The cost of capital is measured in two stages;-
(1) Computation of cost of each component of capital i.e. determination of specific cost;
and
(2)Computation of combined or composite cost termed as weighted average cost which
is used for decision on capital investment

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DETERMINATION OF SPECIFIC COST

COST OF COMMON EQUITY

Two Types of Common Equity Financing

 Retained Earnings (internal common equity)
 Issuing new shares of common stock (external common equity)

COST OF RETAINED EARNINGS (INTERNAL COMMON EQUITY)

Management should retain earnings only if they earn as much as stockholder’s next
best investment opportunity at the same level of risk.
Cost of Internal Equity = opportunity cost of common stockholders’ funds.

METHOD TO DETERMINE STOCKHOLDER’S NEXT BEST INVESTMENT

OPPORTUNITY: DIVIDEND GROWTH MODEL

D1
kS = + g
P0

EXAMPLE
The market price (Po) of a share of common stock is Tshs 60. The prior dividend paid
(D0) is Tshs 3, and the expected growth rate (g) is 10%.

The easiest way to estimate the cost of equity capital is to use the dividend growth model.
Recall that, under the assumption that the firm’s dividend will grow at a constant rate g,
the price per share of the stock, P0, can be written as:

Po = Do X (1 +g) = D1
Re- g Re - g

Where D0 is the dividend just paid and D1 is the next period’s projected dividend.
Notice that we have used the symbol RE (the E stands for equity) for the required return
on the stock.
We can rearrange this to solve for RE as follows:

RE = D1 + g
P0

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Because RE is the return that the shareholders require on the stock, it can be interpreted
as the firm’s cost of equity capital.

EXAMPLE
To illustrate how we estimate RE, suppose Greater States Public Service, a large public
utility, paid a dividend of $4 per share last year. The stock currently sells for $60 per
share. You estimate that the dividend will grow steadily at a rate of 6 percent per year into
the indefinite future. What is the cost of equity capital for Greater States?

COST OF EQUITY SHARE CAPITAL - External Equity New Common Stock

The payment of Dividend on equity shares is not legally binding and rate of dividend not
pre-determined. Some experts hold the opinion that equity share capital does not carry
any cost but this is not true.

Equity shareholders expect fair return on investment and the company also aims at
maximizing the value of shares. If the company will not pay fair dividend the value of the
shares would go down. Thus equity shares carry a cost in terms of return on investment.
Equity shareholders have the following expectations.
• A fair amount of dividend per share available to them every year
• E.P.S should continue to rise regularly over the period
• R.Es in the business to plough back profit resulting in value of shares

THERE ARE FEW APPROACHES FOR CALCULATING THE COST OF EXTERNAL

EQUITY CAPITAL.

1. ADJUSTED DIVIDEND GROWTH MODEL

Cost of External Equity - New Common Stock
– Must adjust the Dividend Growth Model equation for flotation costs of the
new common shares.

D1
kn = P - F + g
0

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EXAMPLE
If additional shares are issued flotation costs will be 12%. D = Tshs 3.00 and estimated
0
growth is 10%, Price is Tshs 60 as before. (Flotation =12% x Tshs 60 = Tshs 7.20)

2. THE SECURITY MARKET LINE APPROACH (SML)-CAPITAL ASSET PRICING

MODEL (CAPM)

Another approach is security market line, or SML

The expected return on a risky investment depends on three things:

1. The risk-free rate, Rf

Guaranteed returns (equivalent to return on government securities)

2. The market risk premium (Rm – Rf)

Reflects risk nature of company’s business activities

3. The systematic risk of the asset relative to average, which we called its beta
coefficient (B)

Cost of equity = Rf + B(Rm – Rf)

Where:
• Rf = Return on risk free investment (e.g. government bonds)
• Rm = Market return (i.e. return achieved from investing across whole of stock
market)
• B (Beta) = Measure of riskiness of investment being appraised (Risk Free
investment would have Beta of 0; Investment in market as a whole would have a
Beta factor of 1)

Example
The current return on government securities is 8%, the average stock market rate of
return is 12% and Jones plc has a beta value of 0.9.
Calculate the cost of equity for Jones plc

EXERCISE
Assume that estimate of the market risk premium (based on large common stocks) is
9.1 percent. U.S. Treasury bills are paying about 2.0 percent Beta coefficients for IBM
had an estimated beta of 0.95. Compute IBM’s cost of equity.

EXERCISE
Suppose stock in Alpha Air Freight has a beta of 1.2. The market risk premium is 8
percent, and the risk-free rate is 6 percent. Alpha’s last dividend was $2 per share, and

Page 5 of 33
the dividend is expected to grow at 8 percent indefinitely. The stock currently sells for
$30. What is Alpha’s cost of equity capital?

UNDERSTANDING BETA AS A MEASURE OF RISK

An investor is concerned with the risk of his entire portfolio and that the relevant risk of a
particular security is the effect, the security has on the risk of the entire portfolio.

This leads us to the following proposition:

The contribution of a security to the risk of a diversified portfolio is measured by the
security’s Beta.
The higher the security’s beta, the more the security raises the risk of diversified
portfolio.

A security’s beta indicates how closely the security’s returns move with the returns from
diversified portfolio Since the returns from the diversified portfolio move with the market
as a whole, beta, also measures how closely the security’s returns move with the market.
• A beta of 1.0 for a given stock means, that if the total value of stocks in the market
moves up by 10% the stock’s price on an average moves up by 10%.
• If the stocks beta is 2.0, its price will rise by 20% under same condition.
• The Beta of the market as a whole is 1.0
• The beta of any portfolio of securities is the weighted average of the beta of the
securities, where the weights are the proportions invested in each security. For
example if 40% has been invested in stock A & 60% in stocks B. and A has a beta
of 1.0 & B has a beta of 1.5 Then the portfolio has a beta of 1.3 = .4 (1) + .6 (1.5)
• Thus beta makes sense as a measure of security risk. A low or negative beta
security is a low risk security because adding it to the portfolio reduces the risk of
the portfolio.
• A stock’s beta can be estimated statistically from the history of its returns and are
also available in published reports.

We can conclude about beta as measure of risk:

1. The value of a diversified portfolio moves with the market as a whole (up and down
together).
2. Beta measures how sharply and closely a security’s price moves on with the market.
3. Adding a high beta (more than 1.0) security to a diversified portfolio increase the
portfolio risk.

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Thus a security’s beta is an important indicator of risk, and a determinant what the people
are willing to pay for the security.

Another formula to calculate cost of equity is = E/P x 100

• E= Earnings per share
• P=Market price per share

COST OF MARKETABLE DEBT

Cost of debt = Interest payable x (1 – tax rate)
Market Price of debt

A company has 1m 8%irredeemable debentures each with a nominal value of £1.

The debentures are currently valued at £1.2m. The company pays corporation
tax at 33%.

COST OF OTHER FIXED RATE DEBT

• Where debt is not marketable (ie: no market price):
• Cost of debt = Interest rate x (1 – tax rate)

EXAMPLE
Suppose that a company issues bonds with a before tax cost (interest) of 10%.
Since interest payments are tax deductible, the true cost of the debt to the company is
the after tax cost.

AT kd = K(1-t), where t= tax rate

EXAMPLE
A company has a 10 year loan with a fixed interest rate of 12%. The company pays
corporation tax at 33%.

COST OF PREFERRED STOCK

Cost to raise a dollar of preferred stock; derived from same formula as a perpetuity.
Required Rate k = Dividend (D )
p p
Net Price (MP - F)

MP=Market price/Market value per share

F=Flotation cost

Example:
You can issue preferred stock for Tshs 45 (Market Price). However, if Flotation costs
are Tshs 3, then the firm only gets Tshs 42 and if the preferred stock pays a Tshs 5
dividend, calculate the cost of preferred stock

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WEIGHTED AVERAGE COST OF CAPITAL
The following steps are required to be taken: -
 Calculate cost of each specific source of capital
 Each source of capital is assigned weight. The total of weights assigned should
not exceed one.
Once we have calculated the cost of each element of a company’s capital, we can
calculate the weighted average cost of capital as follows:

Example Market Value

£mil Cost of capital (after tax)
%
• Ordinary shares 25 15
• Debentures 15 9
• Other debt 10 8

Alternative you can apply the formula below to compute the WACC

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)

WACC = weighted average cost of capital
WT = the weight, or percentage of each element of capital
(% of debt, preferred and common stock to total assets)
ATkd = after tax cost of debt
kp = Cost of preferred stock
ks = Cost of equity (could be Internal or External)

Example
Mbeya Corporation estimates the following costs for each component in its capital
structure:
Source of Capital Cost
Bonds (After-tax) kd = 6.0%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15.5%
New Shares kn = 16.25%

If using retained earnings (Internal Equity) to finance the equity portion :

WACC = (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
Assume that Mbeya Corp’s desired capital structure is 40% debt (WTd), 10% preferred
stock, (WTp) and 50% common equity (WTs).

Page 8 of 33
QUESTION [20 MARKS]
Bamboo Ltd wishes to calculate its weighted Average Cost of Capital (WACC) and the
following is the current information relating to the company
Number of ordinary shares 2 million
Number of 5% Tsh.100 non-callable preferred stock 1 million
Book value of 10% Tsh.1,000 irredeemable bonds Tsh.20 million
Market price of ordinary shares Tsh.50 cum dividend
Market price of 5%, Tsh.100 non-callable preferred stock Tsh.43 ex-dividend
Total dividend just paid Tsh.4 million
Market price of 10% Tsh.1,000 irredeemable debt 105 percent ex interest
Equity beta of Bamboo company 1.5
Treasury bill rate 5%
Expected return in the market 12%

Additional Information
i. The corporate tax applicable to Bamboo Ltd is 35%
ii. The dividends of Bamboo Ltd are expected to grow at an average rate of 6%
REQUIRED:
(a) Estimate the Bamboo’s Ltd equity risk premium and cost of equity using the Asset
Pricing Model (CAMP). [3 Marks]
(b) Calculate the market value Weighted Average Cost of Capital of Bamboo Ltd
Using:
i. Dividend growth model
ii. Capital Asset Pricing Model [12 Marks]
(c) Discuss whether the dividend growth model or the CAPM offers the better estimate
of the equity of the company. [3 Marks]
(d) Discuss the circumstances under which the weighted average cost of capital can
be used in investment appraisal. [2 Marks]

SOLUTION

Part (a) [3 Marks]

Bamboo’s Ltd equity risk premium and cost of equity using CAPM
Equity Risk premium= ( 𝑅̅𝑚 − 𝑅𝑓 )𝛽𝑒
= (12% - 5%) 1.5
=10.5%
Cost of Equity
𝐾𝑒 =𝑅𝑓 + ( 𝑅̅𝑚 − 𝑅𝑓 )𝛽𝑒
𝐾𝑒 = 5% + (12% - 5%) 1.5
𝐾𝑒 = 15.5%

Page 9 of 33
Part (b) [12 Marks]
The market value of weighted Average cost of capital of Bamboo Ltd
(i) Market value using the dividend growth model
Cost of Equity (𝑲𝒆 )

𝐷0 (1+𝑔)
𝐾𝑒 = 𝑝𝑜
+g

𝑇𝑜𝑡𝑎𝑙 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑

𝐷0 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑛 𝑖𝑠𝑠𝑢𝑒

4,000,000
= = 2/= per share
2,000,000

𝑃0 = Market price per share cum dividend – Dividend per share

= 50 – 2 =48
g=6%
𝐷0 (1+𝑔) 2 (1+0.06)
Thus 𝐾𝑒 = 𝑝𝑜
+g = 48
+ 0.06 =10.4%

Cost of irredeemable debt (𝑲𝒊 )

𝐼 10% 𝑥 1,000 100
𝐾𝑑 = = =
𝑃0 1.05 𝑥 1,000 1050

𝐾𝑑 = 9.52%

Thus the after tax cost of debt, 𝐾𝑖 = 𝐾𝑑 (1- T)

=9.52%(1-0.35)

=6.2%

Cost of non-callable preferred stock (𝑲𝒑 )

𝐷 (5% 𝑥 100)
𝐾𝑝 = 𝑃𝑝 = 43
= 11.6%
0

The Weighted Average Cost of capital (WACC)

Market value of equity = 48 x 2,000,000 = 96,000,000
Market value of Debt = 1,050 x 20,000bonds= 21,000,000
Market value of preferred stock = 43 x 1,000,000shares= 43,000,000
160,000,000

96
𝐸𝑞𝑢𝑖𝑡𝑦 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 = 160 = 0.6

21
𝐷𝑒𝑏𝑡 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 = 160 = 0.13

43
𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑜𝑝𝑜𝑟𝑡𝑖𝑜𝑛 = 160 = 0.27

Page 10 of 33
Market value of Weighted Average cost of capital using CAPM
Cost of Equity
𝐾𝑒 =𝑅𝑓 + ( 𝑅̅𝑚 − 𝑅𝑓 )𝛽𝑒
𝐾𝑒 = 5% + (12% - 5%) 1.5
𝐾𝑒 = 15.5%
After tax Cost of debt
𝐾𝑖 = 𝐾𝑑 (1- T)

=9.52%(1-0.35)

=6.2%

Cost of non-callable preferred stock (𝑲𝒑 )

𝐷 (5% 𝑥 100)
𝐾𝑝 = 𝑃𝑝 = 43
= 11.6%
0

Thus the WACC = (0.6)(15.5%) + (0.13)(6.2%)+(0.27)(11.6%)=13.23

Part c [3 Marks]
The dividend growth model vs CAPM

Dividend Growth model

There are a number of problems with dividend growth model. It uses a set of figures which
assumes dividends grow smoothly. In reality, dividend change according to the decisions
made by managers who do not necessarily repeat historical trends. It is therefore very
difficult to accurately predict the future dividend growth rate.

The other problem is how to incorporate risk. The dividend growth model does not
explicitly consider risk, particularly business risk. The company may change its area of
business operations and the economic environment is notoriously uncertain. The share
price will however fall as risk increases, leading to an increased cost of equity.

The model also ignores the effect of taxation and assumes there are no issue costs for
new shares

Capital Asset Pricing Model (CAPM)

The main advantage of CAPM has over the dividend growth model is that, it does explicitly
consider risk. The CAPM is based on the comparison of systematic risks of individual
investments with the risk of all securities in the market.

Systematic risk is the risk that cannot be diversified away and an investor will require a
higher return to compensate for higher risk. This higher return is the higher cost of equity
that is calculated using the CAPM formula. The formula does however require estimates

Page 11 of 33
to be made of excess return/risk premium, the risk free rate and beta value. All these can
be difficult to estimate, but are more reliable than the dividend growth/valuation model.

Conclusion
The CAPM does explicitly consider risk and uses estimated values that are more reliable
than those used in the dividend valuation model. It can therefore be said that CAPM offers
the better estimate of the cost of equity of the company.

Part d [2 Marks]
Circumstances under which WACC can be used in investment Appraisal
The WACC is the average cost of the company’s finance and represents the average
return required as compensation for the risks of the investment.
Business risk
The WACC can only be used if the business risk of the proposed investment is similar to
the business risk of the existing operations. This would involve the expansion of the
existing business. If the proposed investment is in a different type of business, a project
specific cost of capital should be used which reflects the changing risk. The technique to
use involve changing the beta in the capital asset pricing model.

Financial risk
The WACC can only be used where the existing capital structure will be maintained. This
means that the finance for the project will be raised in the same proportion as the existing
finance.

Size of the project

The can only be used if the project being appraised is small relative to the company. If
the project is large in scale, it is more likely to cause in risk and make the WACC
inappropriate.

Page 12 of 33
 CAPITAL STRUCTURE

INTRODUCTION TO CAPITAL STRUCTURE

The fundamental accounting equation is the basis for re-conceptualising capital structure theories
and practices:

BALANCE SHEET MODEL

Assets = Liabilities + Equity
Investment side: Assets = Current Assets + Fixed Assets
Financing side: Liabilities = Current liabilities + Long-term liabilities
Equity: Ordinary Share capital + Retained Earnings

FINANCIAL STRUCTURE AND CAPITAL STRUCTURE

Financial structure refers to the financing side of the balance sheet.

Capital structure refers to the composition of long-term/permanent sources of funds, such as

debentures, long-term debt, preference share capital and equity share capital including reserves
and surpluses (i.e. retained earnings).

A company should plan its capital structure to maximize the use of the funds and to be able to
adapt more easily to the changing conditions. Theoretically, the financial manager should plan
an optimum capital structure for his company. The optimum capital structure is obtained when the
market value per share is maximized or the average cost of capital is minimized.

The capital structure can either be 100% equity OR a composition of both Equity and
Long-term Debt OR a 100% Long-term Debt.

FINANCIAL GEARING (GEARING FACTOR) OR LEVERAGE RATE

Financial Gearing refers to the use of debt in financing the firm’s assets and operations –
current and fixed assets. Strictly Financial Gearing refers to the use of long-term borrowed
funds

MEASURING FINANCIAL LEVERAGE/ GEARING

The Gearing/leverage ratio indicates the proportion of assets which have been financed
by borrowing/external sources. It provides answers to typical questions like: Are the
assets financed mainly by equity (owners) or creditors (externally)? It indicates the assets,
which are claimable by creditors.

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The creditors are interested to know what portion of the total financing of the firm has
been made by the owners in order to know a margin of safety. In case if the funds are
mainly raised by debt, the owners have the control of the firm with a limited investment.
Again if the return on investment is higher than the cost of debt, the return to the owners
increase. However if the cost of debt is more than the return on investment, the owners
will suffer. Where the assets earn more than the interest (cost of debt) the leverage is
considered favorable.

The long term obligations of the firm arise from the capital structure position; that is the
extent to which the firm finances it assets using debt and equity. The higher the proportion
of debt to equity, the leverage the firm is. Whereas leverage could be beneficial especially
in times of economic boom, excessive leverage will mean the firm has high interest
obligations to meet periodically. The firm will also be burdened by meeting the principal
amounts as they fall due. With these two conditions, when these obligations accumulate
to high levels, the survival of firms in the long run will be in a great danger.

Leverage ratios reflect the financial risk exposure of the firm. The more extensive use of
debts the higher would be the firm’s leverage rate.

Financial gearing is indicated by dividing total debt (total liabilities) by total assets.
Financial Gearing ratio = total debt ÷ total assets
Debt Ratio = Long-term Debt ÷ Total Assets

Leverage can also be measured by the relationship between debt financing and equity
financing using the Debt Equity ratio i.e.
Debt Equity ratio = Total Liabilities/Ordinary Equity
OR
Strictly Debt Equity ratio= Long-term Liabilities/Ordinary Equity
Debt-Equity Ratio (TL/Equity) compares external financing with Equity (own sources)
Financing.
The larger the Debt Equity Ratio the more the risk shareholders assume.

DEBT RATIO LIMITS

The gearing ratio (Debt Ratio) has a maximum value of 100% (1.0) and a minimum value
of 0%
Debt Ratio = 100% =All Assets are financed by Debt (100% Debt financing)
Debt Ratio = 0% (0) =All Assets are financed by equity (100% Equity financing.

Page 14 of 33
FINANCIAL GEARING AND PROFITABILITY
Key Questions:
Why Financial Gearing?
Why use of Debt Financing?
To what extent does financial gearing contribute to the profitability of a firm?
How much debt financing is needed?

Given the questions above, a firm’s Board of Directors has to decide whether it should or
not finance its capital investments and current assets using borrowed funds (External
Financing).

Financial Managers should provide information to management and Board of Directors

after analyzing the profitability impact of a combination of Equity and Debt Financing. The
profitability indicators will be earnings per share (EPS), and Return on Equity (ROE).

CONSOLIDATION OF THEORY
Two companies, A and B, both have capital of 100,000,000/=. A has it all in the form of
equity shares of 100/= each, B has 50,000,000/= equity share capital and the balance of
50,000,000/= is in form of 10% loan notes. Both companies earn profits 50,000,000/= in
year 1 and 20,000,000/= in year 2. Tax is assumed at the 35% and dividend paid is 10/=
per share.
The capital position is therefore as follows:

Particulars A B
Tsh Tsh
Shares 100,000,000 50,000,000
Loan notes - 50,000,000
Total capital 100,000,000 100,000,000
What is the earning per share (EPS)?

The effects of different levels of borrowing can be seen as follows:

 Loan interest is an allowable deduction before taxation whereas dividends are paid
out of profit after tax. Company B in the example has consistently higher retained profit
than A.
 Earnings of a company with low equity to assets ratio are more sensitive to profit
changes; This is shown in the table below:

Page 15 of 33
HOW A FINANCIAL MANAGER CAN MAXIMIZE THE VALUE OF THE FIRM IN
MAKING THE FINANCING DECISION

The financing decision is the second most important decision to be performed by the financial
manager after the investment decision. It is the decision concerned with when, where and how to
acquire funds to meet the firm’s investment needs and in doing this, the manager needs to
determine the best proportions of debt and equity in the capital structure. The use of debt affects
the return and risk of the shareholders, which in turn, affects the market value of the shares. To
maximize the market value of the shares and hence that of the firm, the manager needs to
determine a proportion of debt and equity in the capital structure that maximizes shareholders
return with minimum risk. And this a capital structure which is considered to be the optimum
capital structure

FEATURES OF AN APPROPRIATE CAPITAL STRUCTURE

The financial manager of a company should develop an appropriate capital structure which is
most advantageous to the company. This can be done only when all those factors which are
relevant to the company‘s capital structure decision are properly analyzed and balanced.

The capital structure should be planned generally keeping in view the interests of the equity
shareholders. The equity shareholders are the ultimate owners of the company and have the right
to elect the directors. Thus, the financial manager should aim at maximizing the long term market
price per share. However, the interests of other groups, such as employees, customers, creditors,
society and government, should also be given reasonable consideration.

A sound or appropriate capital structure should have the following features:

1. Profitability. The capital structure of the company should be most advantageous. Within the
constraints, maximum use of leverage at a minimum cost should be made.
2. Solvency. The use of excessive debt threatens the solvency of the company. To the point
debt does not add significant risk it should be used, otherwise its use should be avoided.
3. Flexibility. The capital structure should not be inflexible to meet the changing conditions. It
should be possible for the company to provide funds whenever needed to finance its profitable
activities.
4. Conservatism. The capital structure should be conservative in the sense that the debt capacity
of the company should not be exceeded. The debit capacity of a company depends on its ability
to generate future cash flows. It should have enough cash to pay creditors’ fixed charges and
principal sum.
5. Control. The capital structure should involve minimum risk of loss of control of the company.

The emphasis given to each of these features will differ from company to company. For example,
a company may give more importance to flexibility than control, while another company may be
more concerned about solvency than any other requirement. Furthermore, the relative

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importance of these requirements may change with shifting conditions. The company’s capital
structure should, therefore, be easily adaptable.

DETERMINANTS OF THE CAPITAL STRUCTURE

The following factors should be considered whenever a capital structure decision has to be taken:
(i) leverage (or trading on equity) effect on earnings per share, (ii) cost of capital, (iii) cash flow
ability of the company, (iv) control, (v) flexibility, (vi) size of the company, (vii) marketability and
(viii) flotation costs.

1. LEVERAGE EFFECT ON EPS

The use of fixed cost sources of finance, such as debt and preference share capital to finance the
assets of the company is known as financial leverage or trading on equity. If the assets are
financed by the use of debt yield a return greater than the cost of debt, the earnings per share
increase without an increase in the owners’ investment. The earnings per share also increase
when the preference share capital is used to acquire assets. But the leverage impact is more
pronounced in case of debt because (i) the cost of debt is usually lower than the cost of preference
share capital and (ii) the interest paid on debt is tax deductible.

Because of its effect on the earnings per share, financial leverage is one of the important
considerations in planning the capital structure of a company. The companies with high level of
the earnings before interest and taxes (EBIT) can make profitable use of the high degree of
leverage to increase return on the shareholders’ equity.

2. EARNINGS PER SHARE (EPS)

If the objective of the company is to maximize EPS, then the plans with the highest level of debt
will be chosen. In most cases, the EPS criterion will favour debt.

EPS is one of the most widely used measures of the company’s performance. As a result of this,
in choosing between debt and equity in practice, sometimes too much attention is paid on EPS.
EPS, however, has some serious limitations as a financing-decision criterion. These include:

(I) The EPS criterion ignores risk

One of the major shortcomings of EPS is that, it ignores risk. It does not consider the variability
about the expected value of EPS. The belief that investors would be just concerned with the
expected EPS is not well founded. Investors in valuing the shares of the company consider both
expected value and variability.

(II) The EPS criterion ignores long-term perspective of financing decision

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EPS does not consider the long-term perspectives of financing decisions. It fails to deal with the
risk-return trade-off. A long-term view of the effects of financing decisions will lead one to a
criterion of wealth maximization rather than EPS maximization. The EPS criterion is an important
performance measure but not a decision criterion.

3. FINANCIAL RISK

The risk attached to the use of leverage is called financial risk. Financial risk is added with the
use of debt because of:

(a) The increased variability in the shareholders’ earnings and;

(b) The threat of insolvency

A firm can avoid financial risk altogether if it does not employ any debt in its capital structure.
But then the shareholders will be deprived of the benefit of the expected increases in EPS.
Therefore, a company should employ debt to the extent the financial risk perceived by
shareholders does not exceed the benefit of increased EPS. If a company increases its debt
beyond a point, the expected EPS will continue to increase, but the value of the company will fall
or the cost of capital will increase because of the greater exposure of shareholders to risk.

4. GROWTH AND STABILITY OF SALES

One of the very important factors on which the degree of leverage depends is the growth and
stability of sales. The firms with stable sales can employ a high degree of leverage as they will
not face difficulty in meeting their fixed commitments. The likely fluctuations in sales increase the
business risk. As a result, the shareholders perceive a high degree of financial risk if debt is
employed by such companies.

5. COST OF CAPITAL

The cost of a source of finance is the minimum return expected by its suppliers. The expected
return depends on the degree of risk assumed by investors. A high degree of risk is assumed by
shareholders. In case of debt-holders, the rate of interest is fixed and the company is legally
bound to pay interest whether it makes profit or not. For shareholders the rate of dividends is not
fixed and the board of directors has no legal obligation to pay dividends even if the profits are
made by the company. The loan principle amount of debt-holders is returned within a prescribed
period, while shareholders can get back their capital only when the company is wound up. This
leads one to conclude that equity is a cheaper source of funds than debt. This is generally the

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case when taxes are not considered. However, the tax deductibility of interest charges reduces
the cost of debt.

The preference share capital is also cheaper than equity capital, but is not as cheap as debt is.
Thus, using the component, or specific, cost of capital as a criterion for financing decisions, a firm
would always like to employ debt since it is the cheapest source of funds. The specific cost of
capital criterion does not consider the entire issue. It ignores risk and the impact on equity value
and cost. The impact of financing decision on the overall cost of capital should be evaluated and
the criterion should be to minimize the overall cost of capital, or to maximize the value of the firm.

It should, however, be realized that a company cannot continuously minimize its overall cost of
capital by employing debt. A point or range is reached beyond which debt becomes more
expensive because of the increased risk of excessive debt to creditors as well as to shareholders.
When the degree of leverage increases, the risk of creditors increases and they demand a higher
interest rate and do not grant loan to the company at all once its debt has reached a particular
level. Furthermore, the excessive amount of debt makes the shareholders’ position very risky.
This has the effect of increasing the cost.

The excessive use of debt reduces the share price (or increases the cost of equity) and thereby
lowers the overall return to shareholders despite the increase in EPS. The return of shareholders
is made of dividends and appreciation in share prices, not of EPS. Thus the impact of debt-equity
ratio should be evaluated in terms of value, rather than EPS.

The cost of capital and EPS criteria set the maximum limit to the use of debt. However,
other factors should also be evaluated to determine the appropriate capital structure for a
company.

6. CASH-FLOW ABILITY OF THE COMPANY

One of the features of a sound capital structure is conservatism. Conservatism does not mean
employing no debt or small amount of debt. Conservatism is related to the fixed charges created
by the use of debt or preference capital in the capital structure and the firm’s ability to generate
cash to meet these fixed charges. A firm is conservatively financed if it is able to service its fixed
charges under any reasonably predictable adverse conditions.

The fixed charges of a company include payment of interest, preference dividends and principal.
Thus, the fixed charges depend on both the amount of senior securities and the terms of payment.
The amount of fixed charges will be high if the company employs a large amount of debt or
preference capital with short-term maturity. Whenever a company thinks of raising additional
debt, it should analyze its expected future cash flows to meet the fixed charges. It is mandatory
to pay interest and return the principal amount of debt. If a company is not able to generate
enough cash to meet its fixed obligation, it may have to face financial insolvency. The companies
expecting larger and stable cash inflows in the future can employ a large amount of debt in their
capital structure. It is quite risky to employ fixed charges sources of finance by those companies
whose cash inflows are unstable and unpredictable.

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7. CONTROL

In designing the capital structure, sometimes the existing management is governed by its desire
to continue control over the company.

The consideration of maintaining control may be significant in case of a closely-held company. A

shareholders or a group of shareholders can purchase all or most of the new shares and control
the company. Even if the majority shares are held by the owner-managers, their freedom to
manage company will be curtailed when they go public for the first time. Fear of sharing control
and being interfered by others often delays the decision of the closely-held companies to go
public. To avoid the risk of loss of control, the companies may slow their rate of growth or issue
preference shares or raise debt capital. If the closely-held companies can ensure a wide
distribution of shares, they need not worry about the loss of control.

The holders of debt do not have voting rights. Therefore, it is suggested that a company
should use debt to avoid the loss of control. However, when a company uses large amount
of debt, lot of restrictions are put by the debt-holders on company to protect their interests. These
restrictions curtail the freedom of the management to run the business. A very excessive amount
of debt can also cause bankruptcy, which means a complete loss of control.

8. FLEXIBILITY

Flexibility is one of the most serious considerations in setting up the capital structure; flexibility
means the firm’s ability to adapt its capital structure to the needs of the changing conditions. The
capital structure of a firm is flexible if it has no difficulty in changing its capitalization or sources of
funds. The company should be able to raise funds, without undue delay and cost, when needed
to finance the profitable investments. The company should also be in a position to redeem its
preference capital or debt whenever warranted by the future conditions. The financial plan of the
company should be flexible enough to change the composition of the capital structure. It should
keep itself in a position to substitute one forms of financing for another to economize the use of
funds.

The degree of flexibility in the capital structure of a company depends on (i) the flexibility in fixed
charges, (ii) the restrictive covenants in loan agreements, (iii) the terms of redemption and (iv)
the debt capacity.

9. SIZE OF THE COMPANY

The size of a company greatly influences the availability of funds from different sources. A small
company finds great difficulties in raising long-term loans. If it is able to obtain some long-term
loan, it will be available at a higher rate of interest and inconvenient terms. The highly restrictive
covenants in loan agreements in case of small companies make their capital structures very

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inflexible and management cannot run business freely without any interference. Small
companies, therefore, depend on share capital and retained earnings for their long-term funds.
But the cost of issuing shares is generally more in case of small companies than large ones.
Furthermore, resorting frequently to ordinary share issues as a means of raising long-term funds
carries a greater danger of possible loss of control for a small company than to a large company.
The shares of a large company are widely distributed and it is difficult to organize the widely
scattered shareholders against the existing management team. The shares of a small company
are not widely scattered and the dissident group of shareholders can be easily organized to get
control of the company. The small companies, therefore, sometimes limit the growth of their
business to what can easily be financed by retaining the earnings.

A large company has a greater degree of flexibility in designing its capital structure. It can obtain
loans at easy terms and sell common shares, preference shares and debentures to the public.
Because of the large size of issues, its cost of distributing any kind of security is less than that for
a small company. A large issue of ordinary shares can be widely distributed and thus, making
the loss of control difficult. A company should, thus make the best use of its size in planning the
capital structure.

10. MARKETABILITY

Marketability means the readiness of investors to purchase a particular type of security in a given
period of time. Marketability does not influence the initial capital structure, but is an important
consideration to decide about the appropriate timing of security issues. The capital markets are
changing continuously. At one time, the market favours debenture issues and, at another time, it
may readily accept common share issues. Due to the changing market sentiments, the company
has to decide whether to raise funds with a common shares issue or with a debt issue. The
alternative methods of financing should, therefore, be evaluated in the light of general market
conditions and the internal conditions of the company.

11. FLOTATION COSTS

Floatation costs are incurred only when the funds are raised. Generally, the cost of floating a
debt is less than the cost of floating an equity issue. This may encourage a company to use debt
than issue common shares. If the owners’ capital is increased by retaining the earnings no
floatation costs are incurred.

12. COMPETITIVE STRUCTURE OF INDUSTRY

An industry whose entry barriers are cheap can easily have a firms’ target profit margins cut down
unexpectedly. In such industry, debt servicing is usually difficult even if industry sales are steadily
growing. This situation does not favour debt financing.

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 SOURCES OF BUSINESS FINANCE

SOURCES OF BUSINESS FINANCE

Overview of sources of finance

A source of finance could be an individual or institution that supplies finance to the business.
When looking at this area, there are a number of things you need to think about. First of all, you
need to consider why the business needs to raise finance.

Finance can be needed for a variety of different reasons, which will have an effect on what the
most appropriate sources of finance will be.

Finance could be needed for:

i. Starting up a new business

ii. Coping with a cash flow problem
iii. Buying some new equipment or machinery
iv. Setting up a new plant
v. Buying another business (a takeover or acquisition)
vi. Coping with debts

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Sources of finance are mainly grouped into two i.e. short term and long term source

SOURCES OF SHORT TERM FINANCING

Short term finance refers to funds available for a period of one year or less. Short-term finance
is basically used to finance working capital. There are various sources of short term finance
available to the financial manager. These include the following:

i. Trade credit
ii. Accrue expenses
iii. Deferred income
iv. Bank finance
v. Commercial paper
vi. Factoring

TRADE CREDIT

Trade credit refers to the credit a customer gets from suppliers of goods in the normal course of
business. It is mostly an informal arrangement whereby a supplier sends goods to the buyer on
credit, which the buyer accepts and thus, in effect agrees to pay the amount due as per the sales
terms in the invoice.

Trade credit is a spontaneous source of financing as it normally available to the firm.

The advantages of trade credit include the following:-

i. Easy availability

Except in the case of financially very unsound firms, trade credit is relatively easy to obtain and it
requires minimal negotiations.

ii. Flexibility

Trade credit grows with the growth in the firm’s sales. This is because the expansion of the firm’s
sales causes its purchase of goods and services to increase which are financed by credit

iii. Informality

Trade credit is an informal spontaneous source of finance. It does not require any negotiations
and formal agreements in most cases. It also doesn’t have the restrictions that are usually
associated with negotiated sources of finance.

However, although trade credit appears to be cost free since it does not involve explicit interest
charges, but in practice, it involves implicit costs. The cost of credit may be transferred to the
buyer via increased prices of the goods. The financial manager should be well aware of these
costs when making use of trade credit.

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ACCRUED EXPENSES

These are liabilities that a firm has to pay for the services it has already received. They are also
spontaneous and interest free sources of financing. The most important components of accruals
are wages and salaries, taxes and interest.

Accrued wages and salaries represent obligations payable by the firm to its employees. The firm
incurs liability the moment the employees have rendered services although it effects payments
afterwards usually at some fixed interval like one month. The longer the payment interval, the
greater the amount of funds provided by the employees.

Corporate taxes are paid after the firm has earned profits while interest is paid periodically during
a year as the firm continues using the borrowed funds.

DEFERRED INCOME

These refer to funds received by the firm for goods and services that it is has agreed to supply in
the future. These receipts increase the firm’s liquidity in the form of cash, and therefore constitute
an important source of short term financing. Advance payments made by customers constitute
the main item of deferred income.

BANK FINANCE

Banks are the main institutional sources of short-term finance. A bank usually considers a firm’s
sales and production plans in determining the amount of short-term finance to extend to it. The
maximum amount of funds that a firm can obtain from the bank for its short-term finance is called
the credit limit.

Bank finance can take the following forms:

i. Overdraft

Under this facility, the firm is allowed to withdraw funds in excess of the balance in its current
account up to a certain limit during a stipulated period. Interest is charged on the amount
withdrawn subject to some minimum charges.

ii. Purchase of discounting bills

Under this arrangement, the borrower can obtain credit from a bank against his bills. The amount
provided under this arrangement is covered within the overall credit limit.

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 Though the term “bills purchased” implies that the bank becomes the owner of the bills, in practice,
bank holds bills as security for the credit. When a bill is discounted, the borrower is paid the
discounted amount of the bill (i.e. full amount of the bill minus the discount charged by the bank).

iii. Letter of Credit

Suppliers particularly the foreign suppliers, insist that the buyer should ensure that his bank would
make the payment if he fails to honor the obligation. This is ensured through a letter of credit
arrangement.

A bank opens a letter credit in favor of a customer to facilitate his purchase of goods. If the
customer fails to pay the supplier within the credit period, the bank makes the payment. Banks
will always extend such facility to the financially sound customers at a fee.

COMMERCIAL PAPER

Commercial paper is a form of unsecured promissory note issued by firms to raise short-term
funds. The buyers of commercial papers include banks, insurance companies, unit trusts and
firms with surplus funds to invest for a short period (normally, 180-270 days) with minimum risk.

There are two important advantages of commercial paper from the issuing firm’s point of
view.

i. It is an alternative source of raising short-term finance and proves to be handy during periods
of tight bank credit

ii. It is a cheaper source of finance in comparison to bank credit. Usually interest yield on
commercial paper is less than the prime rate of interest.

However, commercial papers have the following limitations:-

i. There are always available to the financially sound and highest rated companies. A firm facing
temporally liquidity problems may not be able to raise funds by issuing new paper.

ii. It cannot be redeemed until maturity. Thus if a firm does not need the funds anymore, it cannot
buy back the papers until maturity and will have to incur interest costs.

iii. If a firm is unable to redeem its paper due to financial difficulties, it may not be possible to get
the maturity of the paper extended.

FACTORING

This is a mechanism that enables a business not to hold accounts receivables until they mature.
The firm passes on its accounts receivables to a factor whose advances it the value of these
receivables after deducting the factoring commission. The factor then undertakes to collect the
amount from the debtor and also bears the bad debts if they occur. The debtors are notified of

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this arrangement and asked to make payments directly to the factor. Since the factor assumes
the risk of default on bad accounts, it must make a credit check before it commits itself.

LONG-TERM SOURCE OF FINANCING

Long-term sources of financing are sources of funds which are employed to finance investment
requirements of a firm for a period exceeding a year. There are several sources of long term
finance that include:-

i. Ordinary share capital

ii. Preference share capital
iii. Debentures
iv. Long-term loans
v. Lease financing
vi. Hire purchase purchasing
vii. Venture capital financing
viii. Bonds

ORDINARY SHARE CAPITAL OR EQUITY CAPITAL

This is capital raised through the issue and sale or ordinary shares to the public. Ordinary shares
provide ownership rights to the holders (investors).

Equity capital is the most important long-term source of financing.

Advantages of equity financing

i. It is a permanent source of capital available to use as long as the company exists. This is
because ordinary shares are not redeemable.

ii. Equity capital increases the company’s financial base and thus its borrowing capacity. This is
because lenders generally lend in proportion to the company’s equity capital

iii. A Company is not legally obliged to pay dividends to ordinary shareholders. Thus, in times of
financial difficulty, it can reduce or suspend payment of dividend to conserve its liquidity position

However equity capital has some disadvantages to the firm and these include the following

i. The ordinary shares are costly to issue and maintain. This is because floatation costs on
ordinary shares are high and dividends are not tax deductible

ii. Ordinary shares are riskier from the investor’s point of view as there is uncertainty regarding
dividends and capital gains

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iii. The issue of ordinary shares dilutes the existing shareholders’ earnings per share if the profits
do not increase immediately in proportion to the increase in the number of ordinary shares.

iv. The issuance of new ordinary shares may dilute the ownership and control of the existing
shareholders

PREFERENCE SHARE CAPITAL

This is a long-term source of capital raised through the issue and sale of preference shares.
Unlike ordinary shares, preference shares have a fixed rate or dividend in addition to other
features.

Advantages of preference share capital include the following:-

i. It provides a riskless financial leverage advantage to the firm since the non-payment of
preference dividends does not force the company into insolvency.

ii. It provides some financial flexibility to the company since payment of preference divided can
be postponed.

iii. Preference dividends are fixed and therefore preference shareholders do not participate in
excess profits, as do ordinary shareholders

iv. Preference shareholders do not have voting rights. Thus, the control of ordinary shareholders
is preserved.

The disadvantages of preference share capital are as follows:

i. Preference dividend is not tax deductible, which makes preference share capital costly to the
firm

ii. Commitment to pay preference dividends and its non-payment can adversely affect the image
of a company, since equity shareholders cannot be paid any dividends unless preference
shareholders are paid

DEBENTURES

Debentures are long term debt instruments that are not secured by a physical asset or
collateral. They are backed only by the general creditworthiness and reputation of the issuer.
Corporations frequently issue debentures to secure loan capital.

A debenture is a long-term promissory note for raising loan capital. The firm promises to pay
interest and principal as stipulated

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Debenture capital has a number of advantages as a long-term source of finance, and these
are:-

i. It less costly to the firm than equity financing because investors consider debentures as a
relatively less risky investment alternative and therefore, require a lower rate of return and also
the interest payments are tax deductible allowance

ii. Debenture holders do not have voting rights and therefore debenture issue does not cause
dilution of ownership.

iii. Debenture holders do not participate in extra ordinary earnings of the company since their
payments are limited to interest

iv. They are beneficial during periods of inflation since the obligation of paying interest and
principal, which are fixed decline in real terms

Disadvantages of debenture capital

i. Debenture capital results into a legal obligation of paying periodic interest and principal on
maturity promptly, which if not paid, can force the company into liquidation

ii. It increases the firm’s financial leverage and hence financial risk which may be particularly
disadvantageous to those firms which have fluctuating sales and earnings

iii. Debentures must be paid on maturity, and therefore, at some points, it involves substantial
cash out flows

iv. Debentures may have restrictive covenants that may limit the company’s operating flexibility
in the future

TERM LOANS

Term loans are loans for more than one year maturity. They are available for a period of between
6 to 10 years though in some cases, maturity could be as long as 25 years.

Usually negotiated with commercial bank, insurance company, or some other financial institution

This type of loan is fully amortized (principal and interest are paid off in installments over life of
loan).

Interest on term loans is tax deductible and most of them are secured through an equitable
mortgage of immovable assets

To protect their interest, lending institution impose a number of restriction on the borrowing firm

LEASE FINANCING

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A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a
capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the
lease to the lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery,
cars and commercial vehicles, but might also be computers and office equipment.

Advantages of leasing include the following

i. It offers convenience to the users as lease financing is less restrictive and can be negotiated
faster especially if the leasing industry is developed.

ii. It provides flexibility to tailor lease payments to the lessee’s cash flows. Such tailored payment
schedules are helpful to a lessee who has fluctuating cash flows

iii. When the technology embedded in assets as in a computer is subject to rapid and
unpredictable changes, a lessee can through a short term cancelable lease shift the risk of
obsolescence to the lessor.

There are two basic forms of lease: "operating leases" and "finance leases".

OPERATING LEASES

Operating leases are rental agreements between the lessor and the lessee whereby:

a) The lessor supplies the equipment to the lessee

b) The lessor is responsible for servicing and maintaining the leased equipment

c) The period of the lease is fairly short, less than the economic life of the asset, so that at the
end of the lease agreement, the lessor can either

i) Lease the equipment to someone else, and obtain a good rent for it, or

ii) Sell the equipment as secondhand.

FINANCE LEASES

Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of the asset (the lessor) for most or all of the assets expected useful life.

Suppose that a company decides to obtain a company car and finance the acquisition by means
of a finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in
a finance leasing arrangement, and so will purchase the car from the dealer and lease it to the
company. The company will take possession of the car from the car dealer, and make regular

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payments (monthly, quarterly, six monthly or annually) to the finance house under the terms of
the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor
is not involved in this at all.

b) The lease has a primary period, which covers all or most of the economic life of the asset. At
the end of the lease, the lessor would not be able to lease the asset to someone else, as the
asset would be worn out. The lessor must, therefore, ensure that the lease payments during the
primary period pay for the full cost of the asset as well as providing the lessor with a suitable
return on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent. Alternatively, the
lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner).

HIRE PURCHASE FINANCING

This is a popular financing mechanism especially in a certain sectors of business such as the
automobile sector.

It involves three parties, the manufacturer, the seller/hiree and the buyer/hirer. The seller may be
a manufacturer or a finance company.

The manufacturer sells the asset to the seller/hiree who sells it to the hirer in exchange for the
payment to be made over a specified period of time

The hire purchase agreement between the seller and the buyer involves the following three
conditions:
i. The owner of the asset (the hiree or the manufacturer) gives the possession of the asset to the
hirer with an understanding that the hirer will pay agreed installments over specified period of
time

ii. The ownership of the asset will transfer to the hirer on the payment of at all installments.

iii. The hirer will have the option of terminating the agreement any time before the transfer of the
ownership of the asset.

The hirer is required to show the hired asset on his balance sheet and is entitled to charge
depreciation, although he does not own the asset until full payment has been made.

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The payments made by the hirer are divided into two parts:-

i. Interest charges
ii. Repayment of principal

The hirer thus gets tax relief on interest paid and not the entire payment

RETAINED PROFIT

This is a source of finance that would only be available to a business that was already in existence.
Profits from a business can be used by the owners for their own personal use or can be used to
put back into the business. This is often called 'ploughing back the profits'.

The owners of a business will have to decide what the best option for their particular business is.
In the early stages of business growth, it may be necessary to put back a lot of the profits into the
business. This finance can be used to buy new equipment and machinery as well as more stock
or raw materials and hopefully make the business more efficient and profitable in the future.

VENTURE CAPITAL FINANCING

Venture capital financing is the investment of long term equity finance. Both the entrepreneur and
the venture capitalist act as partners.

Venture capital financing is usually thought of as an early stage financing for new and young
enterprises seeking to grow rapidly. In fact, venture capital can prove to be a powerful mechanism
to institutionalize innovative entrepreneurship leading to the formation and setting up of small-
scale enterprises specializing in new ideas or new technologies.

Venture capitalists are groups of (generally very wealthy) individuals or companies specifically
set up to invest in developing companies. Venture capitalists are on the lookout for companies
with potential. They are prepared to offer capital (money) to help the business grow. In return the
venture capitalist gets something say in the running of the company as well as a share in the
profits made and capital gain.

Venture capitalists are often prepared to take on projects that might be seen as high risk which
some banks might not want to get involved in. The advantages of this might be outweighed by
the possibility of the business losing some of its independence in decision making.

The main features of venture capital can be summarized as follows:-

1. Equity participation

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Venture financing is an actual or potential participation through direct purchase of shares. Options
or convertible securities. The objective is to make capital gains by selling-off the investment once
the enterprise becomes profitable.

2. Long-term investment

Venture capital financing is a long-term illiquid investment. It is not repayable on demand. It

requires long term investment attitude that necessitates the venture capital firms to wait for a long
period to make large profits

3. Participation in management

Venture financing ensures continuing participation of the venture capitalist in the management of
the entrepreneur’s business. This hands-on management approach helps venture capitalists to
protect and enhance their investment by actively involving and supporting the entrepreneur.

More than finance, the venture capitalists gives their marketing technology, planning and
management skills to the firm.

QUESTIONS

QUESTION ONE
Distinguish between ordinary shares, preference shares and debt as instruments of raising long-
term finance

QUESTION TWO
A securities or stock exchange market is a place for buyers and sellers meet and trade financial
securities at a negotiated price. As a financial manager of medium sized corporation, answer the
following:-
a. Why would you feel a relief with the existence of well-established stock market?

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b. What steps should you take to ensure that your company can benefit from the stock exchange?
QUESTION THREE
a. Explain how the following schemes are used in raising ordinary share capital
i. Rights issue
ii. Issue of prospectus
iii. Competitive bidding
iv. Private placements

b. Explain the role under writers and brokers play in the process of raising funds through the
capital markets

QUESTION FOUR
You have been assigned to raise Tsh5bn from the capital market through issue of ordinary shares.
Explain the alternative ways of issuing these shares open to you

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