Sources of, and raising, business finance

Welcome to Your Guide on Raising Business Finance!

Hello there! Welcome to one of the most practical parts of the Financial Management (FM) syllabus. Think of this chapter as the "shopping trip" for a business. Just like you might need to decide whether to buy a car using your savings, a bank loan, or a credit card, businesses must decide how to get the cash they need to grow.

Don't worry if this seems like a lot of technical terms at first. We are going to break it down step-by-step. By the end of these notes, you'll understand why companies choose certain types of money over others and the unique ways they can raise it.

1. The Big Picture: Categorizing Finance

Before we dive into details, we need to categorize where money comes from. There are three main ways to look at business finance:

A. Internal vs. External

Internal Finance is money the business already has (like Retained Earnings—the profits you didn't pay out as dividends). It’s "free" in terms of transaction costs, but there's a limit to how much is available.
External Finance is money from outside the business, like taking a loan from a bank or selling new shares to the public.

B. Short-term vs. Long-term

Short-term finance (like an Overdraft or Trade Credit) is usually for daily operations.
Long-term finance (like Bonds or Equity) is for buying big assets like factories.
The Matching Principle: Generally, you should fund long-term assets with long-term finance. You wouldn't buy a house using a 30-day credit card, right? The same logic applies to businesses!

C. Debt vs. Equity

This is the most important distinction in FM:
• Equity: Selling a "piece of the pie." You give away ownership, but you don't have to pay the money back.
• Debt: Borrowing the money. You keep ownership, but you must pay interest and eventually repay the original amount.

Quick Review: Internal finance is usually the first choice because it’s easy to access. If that’s not enough, firms look outside!

2. Equity Finance: Selling Ownership

When a company raises equity, it issues Ordinary Shares. Shareholders are the owners; they get to vote and receive dividends if the company does well.

Methods of Raising Equity

1. Rights Issue: Offering new shares to existing shareholders at a discount. It’s fair because it gives current owners the first chance to keep their percentage of ownership.
2. Public Offer (IPO): Selling shares to the general public for the first time. It’s expensive due to legal and bank fees.
3. Placing: Selling shares directly to a few large institutional investors (like pension funds). It’s faster and cheaper than a public offer.

The Rights Issue Calculation

You often need to calculate the Theoretical Ex-Rights Price (TERP). This is the expected market price of a share after the rights issue has happened.

\( \text{TERP} = \frac{(\text{Number of old shares} \times \text{Old Price}) + (\text{Number of new shares} \times \text{Issue Price})}{\text{Total number of shares after issue}} \)

Example: A company has 4 shares at \$10 each and offers a "1 for 4" rights issue at \$5.
\( \text{TERP} = \frac{(4 \times 10) + (1 \times 5)}{4 + 1} = \frac{45}{5} = \$9 \)

Common Mistake to Avoid: Students often forget that "1 for 4" means there are now 5 shares in total, not 4!

Key Takeaway: Equity is permanent finance. It doesn't need to be repaid, but it is "expensive" for the company because shareholders take the most risk and expect the highest returns.

3. Debt Finance: Borrowing Money

Debt comes in many forms, from simple bank loans to complex bonds.

Key Terms in Debt

• Bonds/Debentures: These are "IOUs" issued to the public or institutions. The company pays a fixed interest rate (the Coupon) and repays the Par Value (usually \$100) at the end.
• Convertible Bonds: A cool hybrid! The lender has the option to turn the debt into shares at a future date. Because of this "bonus" option, companies can usually pay a lower interest rate on these.
• Warrants: Often attached to debt, these give the holder the right to buy shares at a fixed price later. It’s like a "sweetener" to make the debt more attractive.

Why use Debt?

1. Cheaper: Lenders take less risk than shareholders, so they demand lower returns.
2. Tax Shield: Interest payments are tax-deductible! This makes the "effective" cost of debt even lower.
Analogy: Imagine if the government paid 20% of your car loan interest for you. That’s exactly what happens for companies through tax relief!

Key Takeaway: Debt increases Financial Risk (Gearing). If the company can't pay the interest, it could go bankrupt. It's a balance of low cost vs. high risk.

4. Islamic Finance

This is a growing part of the FM exam. In Islamic finance, Riba (interest) is forbidden. Instead, finance is based on risk-sharing and underlying assets.

Common Islamic Finance Instruments

• Murabaha (Trade Credit): The bank buys the asset and sells it to the business at a profit. The business pays in installments. No interest is charged; it’s a transparent profit margin.
• Ijara (Leasing): Similar to an operating lease. The bank owns the asset and leases it to the business.
• Sukuk (Islamic Bonds): Instead of receiving interest, Sukuk holders own a portion of an underlying asset and receive a share of the profit it generates.
• Mudaraba: Like a partnership where one provides capital and the other provides expertise. Profits are shared, but losses are borne by the capital provider.
• Musharaka: A full partnership where both provide capital and both share profits and losses.

Did you know? Islamic finance is often seen as more "ethical" or "stable" because it requires money to be linked to real physical assets, preventing excessive speculation.

5. Small and Medium-Sized Enterprises (SMEs)

SMEs face a unique problem called the Funding Gap. This is where a small business is too big for a personal loan but too small for the stock market.

How do SMEs get money?

• Business Angels: Wealthy individuals (think "Shark Tank" or "Dragon's Den") who invest their own money in return for a share of the business and a chance to mentor.
• Venture Capital (VC): Professional firms that invest large amounts of money (from pools of investors) into high-growth, high-risk startups.
• Crowdfunding: Getting small amounts of money from a huge number of people via the internet.

Quick Review: SMEs struggle because they lack a "track record" and have "information asymmetry" (the bank doesn't know as much about the business as the owner does).

Summary Checklist for Success

Before you move on, make sure you can:
1. Identify the difference between internal and external finance.
2. Calculate the Theoretical Ex-Rights Price (TERP).
3. Explain why debt is usually cheaper than equity (The Tax Shield!).
4. List at least three Islamic finance terms and what they mean.
5. Define the "Funding Gap" for SMEs.

Don't worry if this seems tricky at first! Financial Management is all about seeing the "Why" behind the "What." Keep practicing the calculations, and the theory will start to feel like second nature. You've got this!