BUSINESS FINANCE

Chapter 02
Sources & Costs of Finance/Capital – THE CORPORATE
PERSPECTIVE

MUHAMMAD SAMIE
ACA, MBA, APFA

Institute of Administrative Sciences (IAS)

University of the Punjab
Sources of Finance [Companies’ Context]
Ordinary/Common
Stock/Share
Equity Finance/Capital

Preferred Stock/Share

Short-Term
External
ces of Finance

Debt Finance/Capital Long-Term

Medium Term

Convertible Securities
 Sources of Finance
• INTERNAL SOURCES – Raised from the operations or assets of the
business.

• EXTERNAL SOURCES – Raised from outside the business

operations

• Equity Capital – Long Term Finance raised from owners of the

entity

• Debt Capital – Long Term Finance raised from lenders of the entity
 Equity vs. Debt Capital (Companies’ Context]
Compare & Contrast

• Owners vs. Lenders

• Maturity
• Periodic Returns/Costs to company
• Return/Cost Payment Compulsion
• Claim at Dissolution
• Voting Power
• Fluctuating vs. Fixed Return
• Risk Element – Impact on Return
 Equity vs. Debt Capital (Companies’ Context]
Compare & Contrast
EQUITY CAPITAL DEBT CAPITAL
Providers of this finance are termed as owners Providers of this finance are termed as lenders – not owners
This source of finance is Long Term This source of finance is Long, Medium and Short term
Providers of this finance to the company are entitled to periodic Providers of this finance to the company are entitled to periodic
returns in terms of dividends (cost of equity capital for company returns in terms of interest payments (cost of debt capital for
raising it) company raising it)
Payment of dividends for the company is discretionary (not Payment of interest for the company is mandatory as per debt
mandatory) and is governed by company’s dividend policy agreement and is to be paid each year out of profits of the entity.
Claims of owners are settled in the last at the time of dissolution Claims of lenders are settled before owners at the time of
dissolution
Have voting power in the company Have no voting power in the company
They reap the benefits of higher profits and are accordingly Lenders are entitled to fixed return irrespective of the level of
affected at times of losses/lower profits. profits earned by the entity. They cannot reap benefits of higher
profits. But they are not affected by losses/lower profits.
Higher Risk. Owners Demand Higher Return Higher Risk. Lenders Demand Higher Return
 FINANCIAL INSTRUMENT
A CORPORATE TOOL TO RAISE FINANCE PUBLICLY
• Conventional/Normal Methods of Raising Finance (Equity and Debt)
• Concept of Financial Instruments – A Financing Tool for
Corporations
• Application for raising finance
• Equity – Shares/Stocks
• Debt – Bonds, TFCs, Debentures, etc.
• Demonstration of using financial instruments as source of finance
by companies
• Equity and debt instruments are also termed as equity and debt
securities.
 TWO ASPECTS OF EACH SOURCE OF
FINANCE/CAPITAL
PROVIDER/INVESTOR BORROWER/ISSUER
The Person who is providing finance (equity or The company that is receiving/raising finance
debt) to a company through financial instrument or (equity or debt) through financial instrument or
otherwise otherwise
Where finance is raised through financial instrument: Where finance is raised through financial instrument:
Termed as holder of instruments/Investor Termed as issuer of instruments
Investment/Asset (Financial Asset*) Liability/Obligation
Entitled to Periodic returns Periodic returns to be paid to finance providers
These periodic returns are termed as “Return on are periodic costs for finance raisers.
Investment” These costs of raising finance are termed as “Cost
of
Capital”
LEARNING OBJECTIVE: Cost of equity capital is higher for company raising finance (issuer) than
debt capital due to risk-return relationship
* Differentiate between real and financial asset. Also define “asset”
Sources of Finance [Companies’ Context]
Ordinary/Common
Stock/Share
Equity Finance/Capital

Preferred Stock/Share

Short-Term
External
ces of Finance

Debt Finance/Capital Long-Term

Medium Term

Convertible Securities
 Debt Capital
Long Term

• Bank Loan
• Debt Securities/Debt Financial Instruments
• Bonds
• Debentures
• Term Finance Certificates (TFCs)
 Debt Capital
Long Term
BANK LOAN (Loan Sanctioning Process)
• Application for loan
• Fundamental Financial Analysis
• Independent Verification
• Approval
• Loan Agreement
• Loan Amount/Principal – Actual (Original) loan
amount
• Loan Period/Tenure
• Interest rate – (Floating vs. fixed)
• Repayment schedule (Introduction to Basic Debt Schedule)
• Collateral
 Assignment
- Differentiate between public and private limited
companies in the context of Pakistan?

- Differentiate between public sector and public

limited companies?

Search and quote at least 2 examples of each of the following from

the context of Pakistan.
• Public Limited Companies
• Public Sector Companies

- Law(s) regulating companies in Pakistan

 Presentation
A Detailed Overview of Banking System in Pakistan
(Excluding History)

Tentative Dates
Sept 30, 2019 - Monday OR
Oct 03, 2019 - Thursday
 Debt Capital
Long Term
DEBT SECURITIES/DEBT FINANCIAL INSTRUMENTS
Features:
• Face Value/Nominal Value
• Coupon Rate and Coupon Payments (Periodic)
• Maturity Period
• Redeemable vs. Irredeemable instruments
• Repayment Schedule/Style of Debt Instrument (Redeemable instruments)
• Repayment of principal amount is made at the end of maturity period. (Like Scenario 1 of Bank
Loan)
 Debt Capital
Long Term
Redeemable vs. Irredeemable Debt Instruments
Redeemable: These instruments are issued for a certain limited period of time
and repurchased (redeemed) at maturity date. (Like Scenario 1 of Bank
Loan)
Irredeemable: These instruments are issued for indefinite period of time and
are never redeemed back. Instead the holder is paid interest by company
(borrower) forever.
 Debt Capital
Long Term
Bonds vs. Debentures – Compare &
BONDS
Contrast DEBENTURES
Financial Instruments for raising debt finance for Financial Instruments for raising debt finance for long
long term (5, 10, 15, 20 years – even for more years) term (up to 20 years usually)
Providers of debt capital against bonds are called bond Providers of debt capital against bonds are called debenture
holders holders
May or may not be redeemable May or may not be redeemable
They are secured by collateral Not secured by collateral
First Priority of settlement at Liquidation Second Priority of settlement at Liquidation amongst lenders
Less Risky for Lenders High Risky for Lenders
Bond holders charge low rate of return (thereby causing Bond holders charge low rate of return (thereby causing high
low cost for borrower) cost for borrower)
Usually issued by Financial Institutions, Governments Usually issued by public and private limited companies
and government agencies. Companies may also these
instruments
 Debt Capital
Long Term

Term Finance Certificates

• Pakistani debt securities, i.e., issued in Pakistan (like
bonds)
• Used by companies to raise short and medium term finance
(up to 5-10 years usually).
• They are redeemable in nature, i.e., have maturity of
five years usually
• Secured by collateral
 Debt Capital
Short Term
• Overdraft Facility
• Credit Line/Short Term Running Finance (STRF)
• Specific Short Term Loan
• Factoring
• Creditors/Payables (Cost-free finance)
 Debt Capital
Medium Term

Lease - a contract by which one party conveys the usufruct of an

asset to another for a specified time, in return for a periodic payment
(termed as lease rentals).
• Lease vs. Other sources of finance
• Why is lease termed as a source of finance?
Note: Nature and computation of periodic lease payments (lease rentals) and Loan
amortization schedule shall be discussed later.
• LEASE vs. RENT
 EQUITY CAPITAL vs. DEBT INSTRUMENTS
(Comparison
DESCRIPTION
between categories of
COMMON STOCK/SHARES
shares and bonds)
PREFERRED
(ORDINARY SHARES)
Status Owners
Voting Voting Power
Periodic Returns Fluctuating Dividends
Winding Up/Dissolution Settled at the last
Risk/Return by Investors or Highest Risk / Highest return
Lenders/Cost for Issuer charged by shareholders /
Highest cost for company
issuing shares
Redeemable / Irredeemable Irredeemable
STOCK/SHARES (Hybrid
Equity Instrument)
Owners
No Voting Power
Fixed Mandatory Periodic
Dividends (No fluctuating
dividends) - Rate of dividend is
different from common stock
dividend and lenders’ interest
Settled before common
shareholders and after lenders
Moderate Risk / Moderate return
charged by shareholders /
Moderate cost for company
issuing shares
Redeemable / Irredeemable
DEBT INSTRUMENTS
Lenders
No Voting Power
Fixed interest payments
Settled before common and
preferred shareholders and
after lenders
Least Risk / Least return
charged by Lenders / Moderate
cost for company issuing debt
instrument
Redeemable / Irredeemable
 CONVERTIBLE SECURITIES
• Convertible Bonds/Debentures
• Bonds having conversion feature attached therewith.
• Option of convertibility after a certain period of time into common shares (Option
of conversion from the status of lender to owner)
• Conversion terms
• Convertible Preference Shares
• Preference shares having conversion feature attached therewith.
• Option for preference shareholders for getting converted into common
shareholder.
• Conversion terms
 INTERNAL SOURCES OF FINANCE
Retained Earnings – Percentage of annual profits that
are retained for fulfilling the investment needs within
the company
• Advantages
• Prerequisites for retention of earnings
Sources of Finance [Companies’ Context]
Ordinary/Common
Stock/Share
Equity Finance/Capital

Preferred Stock/Share

Short-Term
External
ces of Finance

Debt Finance/Capital Long-Term

Medium Term

Convertible Securities
 CHAPTER 02 | Learning Objectives
• Understanding of sources of finance for the companies/corporate level
• Differentiate between equity and debt capital
• Understanding of financial instrument as a corporate tool to raise finance publicly
• Understanding the borrower/fund raising and lender/investor perspective of any
financial source
• Understanding relating procedure of sanctioning of bank loan
• Differentiate between fixed and floating rate of interest
• Understanding of long term debt instruments
• Differentiate between bonds and debentures
• Understanding of redeemable and irredeemable instruments
• Computation and preparation of repayment schedules for:
• Bank Loan
• Debt financial instruments
 CHAPTER 02 | Learning Objectives (Cont’d)
• Understanding of short term sources of debt finance
• Understanding of lease finance
• How lease differs from other normal sources of finance
• Differentiate between lease and rent
• Clarity of distinction among common shares, preferred shares and debt
instruments
• Understanding of convertible securities
• Understanding of the concept of retained earnings
• Differentiate between public and private limited companies in the
context of
Pakistan.
• Differentiate between public sector and public limited companies.
 SOURCES
PRINCIPLES OF FINANCE
Scott Besley & Eugene F. Brigham

MANAGERIAL FINANCE
Lawrence Gitman

ONLINE LINKS
www.teachmefinance.com

www.studyfinance.com
www.investopedia.com
THANK YOU
 Interest Rates
Borrower’s Perspective
FIXED INTEREST RATE FLOATING INTEREST RATE
Higher Interest Rate Lower Interest Rate
Not affected by financial market conditions Affected by changes in financial market
Budget planning possible Difficult to budget or manage financials
Sense of security May generates savings or cause loss
Lesser risk Higher risk

RETURN
 Public vs. Private limited companies
PUBLIC LIMITED PRIVATE LIMITED
Basic Meaning A public company is a company A private company is a company whose
whose shares are issued to public shares are not traded publicly. Instead
for subscription and their shares their shares are owned by few people.
are traded publicly (Family may be)
Minimum members Public Listed Companies: 7 2 (1 for single member company)
Public Unlisted Companies: 3
Maximum members No limit 50
Suffix Limited Private Limited
Public Subscription Allowed Not Allowed
Transfer of Shares Free Restricted

Examples Of Public Limited Companies: Habib Bank Limited (HBL), MCB Bank, Allied Bank Limited
(ABL), Maple Leaf Cement Factory Limited (MLCFL), Adamjee Insurance Company Limited (AICL),
Examples Of Public Sector Companies: National Bank of Pakistan, Bank of Punjab,
etc.
etc. RETURN
 Debt Capital
Short Term
• Overdraft Facility - An overdraft is a credit facility, but it’s
attached to your existing transaction account. You have access to a
certain amount of credit that becomes available when you exhaust
all the funds in your account.
• Credit Line/Short Term Running Finance (STRF) - A line of
credit (credit line) is an access to a specified credit limit. It allows
you to withdraw sums up to that limit. It falls in the category of
revolving credit (just like credit cards in consumer financing)
RETURN
 Lease vs. Other Sources of
Finance
LEASE OTHER SOURCES OF FINANCE
Asset is transferred and periodic Loan cash flow is provided to the
lease rentals are charged against its person or credit limit is extended
use.
which can then be utilized for the
intended objective. (Even for specified
short term loan)
Lease is offered by leasing companies Loan is extended by banks
or leasing departments of banks.
Medium Term – maximum of 5 years Long term - Can be more than 5 years

RETURN
 Lease vs.
LEASE Rent
Lease is use when an entity wants to use and ultimately
RENT
Rent on the other hand is taking a property for a
own the asset (usually) but does not have enough monthly fee.
capital upfront to buy the same. So, lease provides this
advantage.
Option of transfer of ownership may exist at the end Ownership is not transferred at the end of the rent period.
of lease term
Period payments are termed lease rentals which are Periodic rentals are termed as rent which is based on market
computed based on market interest rate rent prevalent in respect of asset under consideration
Lease Agreement Rent Agreement
Parties: Lessor and lessee Owner/Landlord and tenant
Period of lease: Lease term Period of rent: Rent period

RETURN