Finance Chapter: Debt and Equity Financing

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40 Questions

Which of the following factors can influence a company's financial flexibility?

Type of business operations

What is the purpose of debt covenants imposed by lenders?

To ensure minimum deposit balance in a bank

What is the primary difference between short-term and long-term funds?

Purpose of funding

What do equity shares represent in a business?

Ownership capital

What is the primary consideration for an individual when seeking a source of short-term funds?

Availability of funds

Which type of lending institution is known for providing lending services to its members, who typically pay contributions to the cooperative?

Credit Cooperatives

What is the primary advantage of preference shares over common shares?

Fixed-rate dividend payment

What is the key difference between cumulative and non-cumulative preference shares?

Dividend payment structure

What is the primary disadvantage of short-term loans?

Lump-sum payment plus interest

Which type of lending institution is known for charging higher interest rates than banks but has more lenient credit requirements?

Lending Companies

Which type of preference share may receive dividends from previous years?

Cumulative preference share

What is the primary advantage of informal lending sources such as 5/6?

Wide availability

What is the primary benefit of issuing equity shares to raise funds?

No repayment obligation

What is the primary risk associated with borrowing from any source of funds?

Defaulting on the loan

What is the primary factor that determines the flexibility of a company to access funds?

Ability to pass credit evaluation

Which type of lending institution provides funds in exchange for collateral, usually jewelry or other items of value?

Pawnshops

What is the primary difference between debt-financing and equity-financing?

Debt-financing involves borrowing money, while equity-financing involves selling company ownership

What is the main characteristic of short-term funds?

They are used to finance immediate but temporary capital needs

What is the primary advantage of internally-raised equity?

It does not dilute the ownership of the company

What is the primary difference between a line of credit and a short-term loan?

A line of credit is a revolving credit facility, while a short-term loan is a one-time loan

What is the primary purpose of advances from owners?

To assist the company in sudden liquidity crisis

What is the primary characteristic of suppliers' credit?

It is an extension of payment due date by suppliers

What is the primary advantage of using credit cards for financing?

It provides a pre-approved limit to pay for purchases

What is the primary difference between debt-financing and advances from owners?

Debt-financing involves borrowing from external sources, while advances from owners involve borrowing from internal sources

What is the primary characteristic of redeemable bonds?

They are issued for a specified period of time

What is the primary purpose of a credit report?

To evaluate a borrower's credit history

What is the primary characteristic of non-convertible bonds?

They are not convertible to any equity share

What is the 'condition' that lenders evaluate in a borrower?

Length of employment at current job

What is the primary characteristic of secured bonds?

They are secured by company assets

What is the primary characteristic of registered bonds?

Transfer of ownership is only through a transfer deed

What is the 'capacity' that lenders evaluate in a borrower?

Ability to repay a loan based on income and debts

What is the primary characteristic of convertible bonds?

They can be converted into shares at a stated rate

What is the primary benefit of holding Participating Preference shares?

Participating in surplus profits

What is the main purpose of retained earnings?

Financing business expansion and research

What is the primary requirement for securing a long-term loan from a financial institution?

Providing collateral equal to the loan amount

What type of bond is based on the creditworthiness of the business?

Debenture

What is the primary difference between a non-participating preference share and a participating preference share?

Right to participate in surplus profits

What type of bond allows the holder to receive interest when it becomes due?

Bearer bond

What is the primary advantage of issuing bonds and debentures?

Raising capital for business expansion

What is the primary characteristic of a redeemable preference share?

Redeemability before corporate liquidation

Study Notes

Debt-Financing

  • Raising funds through borrowing money from lenders, including bonds, with a fixed schedule of payment.

Equity-Financing

  • Raising capital by selling company ownership (shares) to investors in exchange for ownership interests in the company.
  • Can be done internally (retaining earnings) or externally (selling shares).

Short-Term Funds

  • Used to finance immediate but temporary capital needs.
  • Gives businesses an extra boost to enhance and expand operations using quick cash.
  • Typically needs to be paid off within 6 months to 1 year, sometimes up to 18 months.
  • Requirements are generally easier to meet, with smaller loan amounts.
  • Some short-term loans don't specify a payment schedule or due date.

Lines of Credit

  • Suppliers' Credit: extension of payment due date by suppliers.
  • Credit Cards: borrowing funds from a pre-approved limit to pay for purchases, with a limit decided by the institution based on credit score and history.

Advances from Owners

  • Personal funds advanced by a stockholder to a company, usually requiring interest.
  • Little to no interest is required, especially if the owner is advancing funds to assist the company in a sudden liquidity crisis.
  • Dependent on the availability of funds of an individual.

Short-Term Loans

  • Involves lower borrowed amounts.
  • Relatively easier to obtain.
  • May require collateral.
  • Can be paid in a lump-sum plus interest.

Sources of Short-Term Loans

  • Credit Cooperatives: provide lending services to members, with members paying contributions.
  • Banks: offer several loan products catering to different needs.
  • Lending Companies: dedicated to lending, with higher interest rates than banks, but more lenient credit requirements.
  • Pawnshops: provide funds in exchange for collateral, usually jewelry or items of value.
  • Informal Lending Sources: charge excessive interest, often 20% per month, with no formal requirements.

Characteristics of Short-Term Funds

  • Cost (Interest): informal lending sources like 5/6 may be the most expensive.
  • Availability: informal lending sources like 5/6 are most available.
  • Risk: lenders may foreclose some of the company's properties or the entire business if the company defaults.
  • Flexibility: influenced by the nature of the company's business, leverage ratio, and stability of operating cash flows.
  • Restrictions (Debt Covenants): some lenders may require a minimum deposit balance or approval before cash dividends can be declared.

Long-Term Funds

  • Used to finance planned and large-scale business operations.
  • Examples: adding a production line, constructing a new branch, funding intense research and development activities.

Equity Shares

  • Represents ownership capital of a business.
  • Can be raised from public by issuing ordinary or preference shares to investors.

Types of Equity Shares

  • Common Shares: represents ownership capital, with owners receiving dividends and return of capital after preference shareholders.
  • Preference Shares: carries rights to receive a fixed-rate dividend and return of capital in case of corporate dissolution.
    • Cumulative Preference Shares: receive dividends from previous years if not paid due to insufficient profits.
    • Non-Cumulative Preference Shares: receive dividends only from available profits in that year.
    • Participating Preference Shares: enjoy the right to participate in surplus profits after all shareholders are paid.
    • Non-Participating Preference Shares: carry no right to participate in surplus profits.
    • Convertible Preference Shares: can be converted into common shares after a specified period.
    • Non-Convertible Preference Shares: cannot be converted into common shares.
    • Redeemable Preference Shares: can be redeemed before corporate liquidation.

Retained Earnings

  • Not all profits are distributed to stockholders.
  • Some businesses retain a part of their undistributed profits to finance further business expansion, fund on-going research and development projects, etc.

Loans from Financial Institutions

  • Banks and credit cooperatives provide long-term loans, depending on the nature of the need and credit rating of the borrower.
  • Requires collateral roughly equal to the loan amount.

Bonds

  • Debt investments where an investor loans money to an entity, which borrows the funds.
  • Bond/Debenture holders are creditors of the business.
  • Interest is payable even when there are no profits made.
  • Can be secured (mortgaged) or unsecured (debentures).

Types of Bonds

  • Bearer Bonds: transferable bonds, with holders receiving interest when due.
  • Registered Bonds: names, addresses, and other information about holders are recorded in a register maintained by the company.
  • Secured or Mortgaged Bonds: bonds secured with company assets.
  • Redeemable Bonds: bonds issued for a specified period of time.
  • Irredeemable Bonds: bonds only repayable when the company goes into liquidation.
  • Convertible Bonds: holders can convert their bonds into common or preference shares at stated rates of exchange, after a certain period.
  • Non-Convertible Bonds: bonds which are not convertible to any equity share.

Characteristics of Borrowers

  • Character: refers to a borrower's credit history, which is their reputation or track record for repaying debts.
  • Capacity: measures the borrower's ability to repay a loan by comparing income against recurring debts and assessing the debt-to-income ratio.
  • Collateral: security pledged for payment of the loan.
  • Capital: a customer's financial resources.
  • Condition: lenders look at the length of time an applicant has been employed at their current job and future job stability.

This quiz covers the basics of debt financing, including borrowing and repayment, and equity financing, including internal and external methods of raising capital.

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