A business might originally have been started using the owner's own capital. Apart from the owners' own funds, there is variety of source of finance available. These source can be short-term, medium-term and long-term.
Short-term finance
Short term finance is required for the business for day to day running business and is normally for a period of up to three year. When we think about the source of the finance, an obvious source is a bank. All the bank offer various kind of finance for business like overdraft, short-term loan, trade credit, factoring, hire purchase etc..
Overdraft
It is usual for a bank permit a certain level of the overdraft when a current account is opened. A deposit account usually requires a period of notice before fund can be withdrawn, and is not suitable for the organization to make a payment. In current account fund can be take it out whenever it is necessary. Current account has earned less interest than the saving accounts, and some pay no interest at all. If overdraft is granted, no money is actually credited to the current account, but the business is allowed to run the account down to zero and then a further pre-arranged amount can be withdrawn, hence the term 'overdraft'.
Interest on an overdraft is only paid only on the amount actually overdraft if overdraft is granted by bank is for £3000 and the business only use £ 2500 of it, the interest is only charged on this lower amount and not on the full amount on overdraft, If business quickly return its current account to a credit balance, it will not have to pay much interest.
Short-term loan
Another source available from a bank is a loan. Short - term loan to be used to buy specific pieces of equipment or to purchase a raw material in order to fulfill a contract. The amount of the loan is opened and the full amount is credited to the business current amount, if settlement are made, they are taken that amount from the business account and paid in to a loan account this reduce the outstanding amount on the loan.
The amount of interest payable on an overdraft is higher than the amount charge in a loan.
Trade credit
Trade credit refer to credit granted to manufactures and traders by the supplier of raw material, finished goods, components, etc. usually business enterprises buy supplies on a 30 to 90 days credit. This means that good are delivered but payments are not until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance
Factoring
this means a business selling its debts to raise finance. Debt often takes the form of an 'IOU'. With regard to the example, assume that Pepsi is holding a signed invoice from one of its large customers called Poundland. In this document, Poundland agree to pay £200000 in one month's time for the soft drink it has received. The problem is that the Pepsi needs the money immediately to pay its employees and the interest on its bank loan. This debt can be sold to a factoring company. Specialist companies exist for this, although most banks offer factoring services.
The factoring company will offer a certain percentage of the debt to Pepsi and will then legally own the debt. When the payment becomes due, Poundland will pay the factor and not Pepsi. The factoring of the debt makes little, if any, different to Poundland, which will only pay what it owed anyway.
Hire purchase
Hire purchase is a method of paying for an item in installments over a period of months or year. The machinery hired by the business while the payment are being made, does not actually become a business property until the last payment is made. All forms of credit, hire purchase has the benefit that the large sum of money.
Customer advances
Businessmen insist on their customer to make advance payment. The value of order is large and things ordered are very costly that time generally asked about the advanced payment. The advance payment is on the price on the product which will be delivered at a later date. When good are not easily available in the market or there is an urgent need of goods that time generally customer agree to make advances. A business can meet its short-term requirements with the help of customers' advance.
Medium term finance:
Medium term finance is normally for a period of between three and ten years. this called medium term finance sources:
Medium term loan
As is the case with a short term loan, an agreed amount is credited to the business's current account. For a medium term loan, the rate of interest charged by the bank is particular important. If the Soundrive wants a loan to finance because of new technology expand. The amount of interest payable on a medium-term loan depends on several factors:
How much is borrowed
How long the money is wanted for
The security that is provided.
Example: A company has the option to choose either a variable rate or a fixed rate loan. That means that the amount of interest which a company pays varies, according to the bank decisions on interest rate. The fixed rate loan has advantages of certainty: if a company takes a fixed rate loan, then those running the business will know what the repayment costs are going to be. This will make financial planning easier the company will not be financially disrupted by a rise in interest rates.
Hire purchase and leasing
Hire purchase: hire purchase mentioned as source term finance and it consider as a method of medium term finance
Leasing is same in that it also allows payment to be made in installment, spending the cost over number of years. Hire purchase means that the total amount finally paid will be in excess of the cash price.
Leasing mean the item is on rent that means the business that leasing something never actually own it , unless the leasing company sell to the business when the agreement comes to an end.
Example: if company wants a new network with specific facilities for computer-aided design and computer-aided manufacture, but the company cannot afford to pay for it all at once, it could contact a leasing company with the proposal to lease the equipment for seven years, If the leasing company agree, the equipment will be installed. Payment are made monthly but, unlike with hire purchase, the leased item do not become the property of soundrive at the end of the seven years.
Long term finance
A business requires funds to purchase fixed assets like building and land, plants and furniture, machinery etc. These assets may be regarded as a foundation of the business. The capital required for the assets is called fixed capital. Working capital is also of a permanent nature. Funds required for the working capital and for fixed capital are called long term finance.
Long term loans
Long - term loan use for expensive machinery, which cost take a long period of time, perhaps as long as 20 years.
Loans for building are knows as mortgages and its duration of between 20 years and 30 years. The amount of finance is very large and bank will certainly require accomplishment the security.
Debentures
Debenture means the company does not borrow money from the bank in the usual way, but the debenture for the raise finance .the debenture has fixed rate of interest which the company must pay to the debenture holders every year. And the debenture can be resold to someone the investor need money back before the debenture matures. Debenture are secured on specific assets of the company if the company has financial problem the debenture holder can force to the company to sell the assets in order to get their money back.
The issue of shares
The issue of the share is also known as equity finance. When investors use the term equities, they are talking about share. This type of finance available to a company
The private company has many rules and regulation for the transfer of share because they are not trade in the market. In the public company issued share they are then trade on the stock market, where the debenture and shares are bought and sold. Public company are able to raise their finance than private company but in either case the share are issue for ever; they are not like debenture and loan which are paid back. When the company issued more share is called right issue. In this case existing shareholder are offered the opportunity to buy more shares at the lower price than current market value.
Sale and leaseback
The Company can raise their money by selling off an assets such as a piece of land and building this can raise amount of the finance and is a sensible course of action if the assets is not longer needed.
Sale and leaseback is where the asset is sold but then leased back, usually for a long period of time. If company not use their factory and they agree to lease it back for 20 years. If company needs more finance in order to fund an expansion, it can raise finance in this way in the knowledge that it can operate from exactly the same site as before for many years.
Retained profit
If company gain profit from several years, it likely some of the profit will be retained for the purpose of using it in the future. Retain on profit is useful source in the finance which does not incur debt in the company. As these retained profits have been used to finance the business and not distributed to the owners, there will be entry in balance sheet in the liabilities section of the business under the heading ' retained profit' or 'profit and loss account', since this is where the profit was originally recorded in the accounts.
QUE.2 A company is considering which of two mutually exclusive project it should undertake. the finance director think that the project with the higher NPV should be chosen whereas the managing director think that the one with the higher IRR should be undertake especially as both project have the same initial outlay and length of life. the company anticipate a cost of capital of 10% and net cash flows of the project are as follows:
Year
0
Project X£(000)
Project Y£(000)
1
35
218
2
80
10
3
90
10
4
75
4
5
20
3
Calculation of NPV and IRR
Net present value ( NPV):
The net present value method of DCF analysis is to calculate a net present value for a proposed investment project. The NPV is the value obtain by discounting all the cash outflows and inflows for the project at the cost of capital, and the adding them up. The cash inflows are positive value and outflows are negative. The sum of the present value of all the cash flows from the project is the 'net' present value.
If the net present value is £0 that means the project earn exactly the specified rate.
If the net present value is negative that mean the project earn less than the specified interest rate.
If the net present value is positive that means the project earning more than the interest.
NPV=
Calculation of the discount factor of the five years when discount rate is 10%:
1st years discount factor =
=
=0.909
2ed years discount factor =
=
=0.826
3rd years discount factor =
=
=0.751
4th years discount factor =
=
=0.683
5th years discount factor =
=
=0.621
years
Project X
cash inflow
Discount factor
Present value
0
£(200)
1.000
£(200)
1
35
0.909
31.82
2
80
0.826
66.08
3
90
0.751
67.59
4
75
0.683
51.23
5
20
0.621
12.42
Net present value of project X = 29.14
Project Y net present value is
years
Project Y
cash inflow
Discount factor
Present value
0
£(200)
1.000
£(200)
1
218
0.909
198.16
2
10
0.826
8.26
3
10
0.751
7.51
4
4
0.683
2.732
5
3
0.621
1.863
Net present value of project Y = 18.53
According to finance manager one of project has higher NPV should be selected. Finance manager selected project X because the project X has a higher NPV than project Y, that means the project Y is rejected.
2.2) Internal rate of return ( IRR) -
The internal rate of return method of DCF analysis is to calculate the exact DCF rate of return that the project is expected to achieve. This is the cost of capital at which the NPV is zero.
If expected rate of return is higher than the target rate of return, the project is financially worth undertaking.
If we have two cost of capital, where the NPV goes to 0 that time manager can estimate cost of capital at which NPV is 0. In order to marketing manager estimate the internal rate of return and marketing manager estimate 20% of the cost of capital in order to calculation is below:
The discount rate is 20% that time net present value is
1st years discount factor =
=
=0.833
2ed years discount factor =
=
=0.694
3rd years discount factor =
=
=0.578
4th years discount factor =
=
=0.482
5th years discount factor =
=
=0.402
years
Project X
cash inflow
Discount factor
Present value
0
£(200)
1.000
£(200)
1
35
0.833
29.16
2
80
0.694
55.52
3
90
0.578
52.02
4
75
0.482
36.15
5
20
0.402
8.04
Net present value of project X = -19.11
Project Y net present value is
years
Project Y
cash inflow
Discount factor
Present value
0
£(200)
1.000
£(200)
1
218
0.833
181.59
2
10
0.694
6.94
3
10
0.578
5.78
4
4
0.482
1.93
5
3
0.402
1.22
Net present value of project Y = -2.54
The net present value is less than 0 resulted of the marketing manager decide which project has higher IRR which one is under take.
Calculation of IRR of the project X and project Y is as below:
IRR=
Project X IRR =
=
= 0.10+ (0.604*0.10)
Internal rate of return of project X= 0.1604 =16.04%
Calculation for the project Y IRR as below:
Project Y IRR =
=
= 0.10+ (0.878*0.10)
Internal rate of return of project Y= 0.1878 =18.78%
The project is expected to earn a DCF return in excess of the target tare of 18.78%, so (ignoring risk) on financial ground it is a worthwhile investment.
