Introduction : Finance is very important to meet the organisational objectives or goals ineffective and efficient manner. In a global business world different source of finance available. This source of finance depending on a amount of a capital required and the time period to pay back. Business need a finance for new business, for a working capital and for expand a business.
Main body : Sources of finance are categorise in short term and long term finance. Sources of short term finance can be paid back within a one year while, long term finance can be paid back over one year.
Main Body:
Short term finance:
Bank credit : Bank provide a finance for short period to company or firms is called as a bank credit. When the bank credit allowed, then borrower can withdraw finance in instalments or whole amount of loan. These finance may be in a form of discount bills, overdrafts, cash credit and loans.
Overdraft : Customer or business organisation can withdraw amount from the bank, more then his or her account balance with terms and condition. Most banks know every businesses do not receive money regularly. If you run a shop in your local area then you might get money directly when you sell your product. if you have a business about raw material of building to a building material retailer, then you may not get paid straight away when you deliver your goods. When difference comes out from revenue and expenditure(less revenue then expenditure ) in a firm or organisation, they can face liquidity or financial problems. In this situation overdraft is very helpful for the business. The business will get charged interest on the amount they have used. Example, The overdraft facility is £ 7000, if the business only uses £ 3000 of that limit, they only pay interest on the £ 3000, not the whole £ 7000. This is the important difference between loan and overdraft. The rate of interest is high in this overdraft facilities.
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Cash Credit : Customer or Borrower can withdraw some amount from the bank on certain limit, this limit known as a cash credit. This limit is for one year after one year borrower can renewed it. Rate of interest is depend on amount of limit. Bank ask for collateral security for a grant of cash credit. Interest is charged on only withdrawn amount.
Loans : Borrower can get certain amount in advance against security of assets. He or she has to pay this amount in specified time period with interest. The amount credited in a separate account.
Trade credit : In a trade credit period of time given to a business to pay for goods that they have received. It is from often 28 days to 6 months. Example, Priya furniture is a small organisation in Bombay. They are makes all type of furniture for the house. They are always get the order and made to suit the specific requirements of the customer. When they receive a delivery from their supplier they do not pay straight away. They will receive a 28 days period before having to pay the bill without charge of interest. After the 28 day supplier will charge interest. For small business like Priya furniture trade credit is a useful source of short term finance.
Leasing: Most businesses have to buy equipment, machinery and buildings but lack of finance pushing them towards leasing. Some time because of leasing they can reduce a cost of product by low rate of lease. In this situation leasing is a suitable option for the business. The means of leasing is agreement between two parties for use of product or service for certain amount and time. In the end of agreement owner will be same. Example: A lease agreement on a car. Might mean that the firms pays out £ 200 per month for a 3 years lease. At the end of the 3 years the car returns to the owner. Lease agreement can be of benefit to the firm for the following reason.
lease can be cheaper than buying a equipment outright.
Owner of the equipment or building is responsible for the maintenance and that's why cost of product can be reduce.
Specially for the project it's a very suitable.
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Long term finance :
In a long term finance pay back time is over 1 years. Long term finance may be needed for the long term project, set a new offices in other country, or buying a company and expansions of companies.
Shares : Organisation can get a fund by share issue for their long term financial objectives. Shares relate to companies set up as private limited companies or public limited companies. There are many advantages and disadvantages of issuing shares. Small organisation can issue shares for just two share holders. If the business want to expand , they can issue more shares but there are limitations on who they can sell shares to any share issue has to have the full backing of the existing shareholders. Public limited companies are different , they can sell their shares to the general public issue. Example: Reliance communication and Tata company has got fund by shares.
Types of shareholders:
Equity shareholders: This share holders have not a specific right. If the organisation get a profit, then they will pay first to preference shareholders. Then they retain some profit for their organisation. And in the end they will get a profit, if they have. So they are real risk takers and care takers of the company and they enjoy the right of voting.
Preference share holders: These are a lower risk class of share which give 'first right' to a dividend from the company ahead of the ordinary share holder, which is useful in bad times. But the dividend is usually fixed and so preference shares never share in the growth in the company. It's like a pond from a company to an investor that pays interest but preference shareholders would be behind bondholders In the priority payment queue.
Existing shareholders - Right issue : Some time Public Limited Company need more fund for their business expansion, that time they can issue shares. Many Company or organisation will do this through what is called 'right issue'. This happen where new shares are issued but existing shareholders get the right to purchase new additional shares at a reduce price.
By this sources company or organisation fulfil their long time financial objectives.
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International financial institutions : National and World bank and international finance corporation provide long term funds for the industrial development all over the world. The world bank grants loans only to the governments of member countries or private enterprises with guarantee of the concerned government. IFC ( Industrial Finance Corporation of India ) was set to assist the private undertaking without the guarantee of the member countries. It also provides them risk capital. Many financial institutions are established by state or central government. They are giving loans at lower interest rate. Those institutions are as follow.
World bank.
Industrial finance corporation of India.
Industrial development Bank of India.
Unit trust of India.
Debentures : When the company need a long term finance for large amount for the fix period, Company can get finance by general public issue by issuing loan certificates. Total amounts of borrowing is divided in unit of fixed amount like £ 100, is called Debentures. Debentures are different from ordinary shares because
The debenture holders has no voting rights in the company.
Debenture holders are interested in a interest for certain time and income.
In the failure of business debenture holder paid out before ordinary shareholders.
Company could get fund without debenture holders control over the company. The interest of debenture is an expense and is charge to the profits of the company.
Retain profit : This is a source of finance that would only be available to a business that was already in existence. Re-invest of profit for the expansion of business or fulfil their financial requirement in a business. This often called a 'ploughing back the profit'. The owners of a business will have to decide what is the best option for their particular business. In the early stage of business growth, it may be necessary to put back a lot of the profit in to the business. This finance can be used to by new equipment and machinery as well as more stock or inventory and hopefully make the
business more efficient and profitable in the future. Retain profit is a cheaper source of finance. Page No.4
Section - B , Question - four.
For better growth company or organisation need to expand a excellence services and products while for the more profit they have to select a best option for a service development, product or project. That is not easy to choose a option about a different project. Take a suitable option which is most appropriate for return on investment. Every investors needs a maximum return on his project.
Main Body :
NPV ( Net Present Value ) is a difference between the present value of the future cash flows from an investment and the amount of the investment. Present value of the expected cash flows is computed by discounting them at the required rate of return.
Importance of NPV: By suitable project, management could get a positive NPV and result of that, shareholders wealth would be increase. Negative NPV reduce the wealth of shareholders. Because main objectives of the management's is increase maximum wealth of shareholders.
IRR ( Internal Rate of Return ) is a measures of your investment performance. it's indicate yearly return on a investment. In calculation system IRR define as the interest rate - r or discount rate that would make present value 0. NPV may be positive or negative.
To calculate the NPV and IRR, first of all we need to calculate the discount factor of each year as follow:
The discount rate which is used in financial calculations is usually chosen to be equal to the Cost of Capital. The Cost of Capital, in a financial market equilibrium, will be the same as the Market Rate of Return on the financial asset mixture the firm uses to finance capital investment. Some adjustment may be made to the discount rate to take account of risks associated with uncertain cash flows, with other developments.
Discount factor = 1/(1+r)n
Where r = discount rate and n = numbers of years.
so discount factor at 10% are as follow:
1st year = 1/1.1 = 0.909
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2nd year = 1/(1.1)2 = 0.826
3rd year = 1/(1.1)3 = 0.751
4th year = 1/(1.1)4 = 0.683
5th year = 1/(1.1)5 = 0.621
The net present value :
The net present value ( NPV ) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV)
Year
Discount Factor
For Project - X
For Project - Y
0
1
2
3
4
5
NPV
The opportunity cost of capital at rate of 10% are as follow:
NPV for Project - X = 29.26
NPV for Project - Y = 18.52
Internal Rate of Return :
The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR).
IRR = L% + [ NL/(NL-NH) X (H-L)%]
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L% = lowest discount factor rate
H% = highest discount factor rate
NL = NPV of lowest discount rate
NH = NPV at highest discount factor rate
Now we calculate the discount factor at the rate 20%,
Discount factor :
1st year = 1/1.2 = 0.833
2nd year = 1/(1.2)2 = 0.694
3rUd year = 1/(1.2)3 = 0.578
4th year = 1/(1.2)4 = 0.482
5th year = 1/(1.2)5 = 0.402
NPV of both the project at to different rate are as follow:
Year
0
1
2
3
4
5
NPV
By using the NPV value at two different rate of discount factor we can calculate IRR value of project X and Y
For project X
L% = 10%
H% = 20%
NL = 29.26
NH = (19.11)
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IRR for project X = 10% + [ 29.26/29.26-(-19.11) X (20-10)%]
= 10% + 6.04% = 16.04%
IRR for project Y
L% = 10%
H% = 20%
NL = (2.56)
NH = 18.52
IRR for project Y = 10% + [ 18.52/18.52-(2.56) X (20-10)% ]
= 10%+ 8.78% = 18.78%
We have a ranking problem with these two project as the cash flow pattern is inconsistent between the two. Project X has mixed cash flows which rise in the first three years then drop off where as Project Y has cash flows that decrease from year 1 onwards. Project Y seems very unusual since the first net cash flow covers up the initial expense yet the succeeding years have menial net cash flows but the net present value of future cash inflows in both projects exceeds that of outflows, positive NPV results and both the projects accepted but if we compare the project x and project y I recommend to undertake project X which giving more NPV at the end of 5 years, so the investment in project X is worthwhile.
When in real life we are faced with ranking issues of this nature where patterns of cash flow differ for equal life projects, we are likely to chose a project with the highest NPV the reason lies with the fact that in computing NPV we assume the reinvestment rate is same for both project which is usually the discount rate or the cost of capital in this case 10%. This differs from the assumption in computing IRR where the reinvestment rate is different for both projects since IRR is considered the reinvestment rate and it will be different for both projects as is the case here.
Conclusion : Investors needs a maximum return on their investment. They have calculation on their investment which is invest in any organisation. They are using NPV and IRR formula for it. To fulfil the investors and organisational objectives. Maintain the all financial resources within a system. If you are going fail to maintain these
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resources organisation will get a risk of collapse. Lack of finance and more finance both are risky for the organisation. In case of more finance you have to pay interest, which is not suitable for the organisations financial system. Lack of finance pushing the organisation towards collapse because they can not meet their financial objectives without funds.
