Sources of finance and their relative costs

Welcome to the World of Business Finance!

Hi there! Welcome to one of the most practical and important parts of your Financial Management (FM) journey. Think of a business like a car: it can be the most beautiful car in the world, but it won't go anywhere without fuel. In the business world, finance is that fuel.

In this chapter, we are going to explore where companies get their money (sources) and why some "fuel" is more expensive than others (relative costs). Don't worry if this seems a bit overwhelming at first—we’ll break it down into simple, bite-sized pieces that make sense.

1. Internal vs. External Sources of Finance

Before we look at specific types of money, we need to know where it comes from. There are two main "neighborhoods" for finding finance:

Internal Finance: This is money the company generates itself. The most common example is Retained Earnings (profits that aren't paid out as dividends). It’s like using your own savings to buy a bike instead of asking your parents for a loan.

External Finance: This is money brought in from outside the business. This includes things like bank loans, issuing new shares, or leasing equipment. It’s like taking out a credit card or a mortgage.

Quick Review: Internal finance is usually "cheaper" because there are no transaction costs (like bank fees), but there is a limit to how much a company can save up!

2. Short-term vs. Long-term Finance

When choosing how to fund a project, managers look at how long they need the money. A golden rule in FM is the Matching Principle: use short-term finance for short-term needs and long-term finance for long-term assets.

Short-term sources:
- Bank Overdrafts: Very flexible but usually have high interest rates.
- Trade Credit: Buying goods now and paying the supplier in 30 or 60 days. It’s basically an interest-free loan!
- Leasing: Instead of buying a van, you "rent" it over a period.

Long-term sources:
- Ordinary Shares (Equity): Selling "pieces" of the company to investors.
- Long-term Loans/Bonds (Debt): Borrowing money for 5, 10, or 20 years.

Did you know? Using a long-term loan to buy inventory that you'll sell in a month is like using a 30-year mortgage to buy a loaf of bread—it's not very efficient!

3. Equity Finance: Owning a Piece of the Pie

Equity finance comes from the owners (shareholders). When you buy a share, you become a part-owner of that company.

Ordinary Shares: These carry the most risk. If the company goes bust, shareholders are the last people to get paid. Because they take the most risk, they expect the highest return.

Rights Issues: This is when a company offers existing shareholders the "right" to buy new shares, usually at a discount to the current market price.
- Step 1: The company announces the ratio (e.g., a "1 for 4" issue).
- Step 2: Shareholders can buy, sell their rights, or do nothing.
- Common Mistake: Students often think a rights issue makes shareholders poorer because the share price falls. Actually, the value of their total "wealth" usually stays the same because they own more shares at a lower average price!

Key Takeaway: Equity is permanent capital. The company never has to "pay it back" like a loan, but it is the most expensive source of finance because of the high risk to the investor.

4. Debt Finance: Borrowing the Money

Debt is money borrowed from lenders (like banks or bondholders). Unlike equity, debt must be repaid, and interest must be paid regardless of whether the company makes a profit.

Types of Debt:
- Bank Loans: Direct borrowing from a bank.
- Debentures/Bonds: The company issues "IOUs" to the public or institutions. They pay a fixed interest rate (called a coupon).
- Convertible Bonds: A cool hybrid! These start as debt (paying interest), but the holder has the option to turn them into shares later. This makes them attractive to investors, so the company can often pay a lower interest rate.

Why is Debt cheaper than Equity?
There are two big reasons:
1. Risk: Lenders are paid before shareholders. Lower risk for them means they accept a lower return.
2. Tax Efficiency: Interest payments are tax-deductible. If a company pays \( \$100 \) in interest and the tax rate is \( 20\% \), the "real" cost to the company is only \( \$80 \). Equity dividends do not get this tax break!

5. Islamic Finance

ACCA requires you to understand the basics of Islamic finance, which follows Sharia law. The main rule? Interest (Riba) is forbidden. Instead, finance is based on profit-sharing and underlying assets.

Key Terms to Remember:
- Murabaha (Trade Credit): The bank buys the asset and sells it to the business at a markup. It’s like buying a car for \( \$10,000 \) and selling it to you for \( \$11,000 \).
- Ijara (Leasing): Similar to a traditional lease where the bank owns the asset and the business pays to use it.
- Mudaraba (Equity Finance): One party provides the money, the other provides the expertise. Profits are shared.
- Musharaka (Venture Capital): Both parties provide money and expertise. Both share profits and losses.
- Sukuk (Islamic Bonds): Unlike traditional bonds that pay interest, Sukuk represent ownership in an asset and pay a share of the profit generated by that asset.

6. The Pecking Order Theory

If a manager needs money, which source should they choose first? The Pecking Order Theory suggests they follow this order based on ease and cost:
1. Retained Earnings (Use your own cash first—it’s easy and has no issue costs).
2. Straight Debt (Borrow it—it's cheaper than equity and doesn't dilute ownership).
3. Convertible Debt.
4. New Equity (Last resort—it’s expensive to issue and tells the market you’ve run out of cash!).

7. Relative Costs and the Risk-Return Trade-off

In FM, Risk and Return are best friends—they always go together.
- Investors: If they take more risk, they want more return.
- Company: If the investor wants more return, it costs the company more.

The Hierarchy of Costs (from cheapest to most expensive):
\( Debt < Convertible \ Debt < Preference \ Shares < Equity \)

Why?
- Debt is safest for the investor (and has tax benefits for the firm).
- Equity is the riskiest for the investor (they might get nothing if the company fails).

Summary Quick Review

1. Equity is permanent, high-risk for the investor, and expensive for the company.
2. Debt must be repaid, is lower risk for the lender, and is cheaper for the company due to tax relief.
3. Islamic Finance focuses on sharing risk and reward without using interest.
4. Matching Principle: Match the length of the finance to the life of the asset.
5. Tax Shield: Don't forget that interest reduces your tax bill, making debt even more attractive!

Don't worry if the formulas for calculating these costs (like \( K_e \) or \( K_d \)) seem tough—we will cover those in the Cost of Capital chapter. For now, focus on understanding "why" we choose one source over another!