Factors considered to choose the right source of finance are the Cost of Finance, Attached Risk, Dilution of Control, and Flexibility of Repayment. Comparing various alternatives and evaluating them based on these crucial factors helps build an optimum capital structure for the business. In today’s scenario, the business operates in a dynamic environment. Decision-making plays an important role, especially when such decisions are concerned with procurement and finance usage, which is an organization’s lifeblood.
An efficient financial management calls for various kinds of decision-making. A major decision for any organization is to decide the sources for procurement of funds. Broadly, the finance category available for any business is debt and equity. The proportion of financing from these two determines the capital structure. While making such a decision, one needs to ensure that it suits the business conditions.
For example: For a new business, equity might be a better source than debt. Procurement of funds via debt requires a disciplined repayment of interest and principal. So to honor the debt obligations, one needs regular and timely cash flow, which is a common challenge for a new business.
The main objective behind deciding on sources of finance is to build such a capital structure that optimizes the firm’s value. Generally, businesses use a combination of different finance sources. Before one decides on the mix to be used for raising funds, it is imperative to know about these sources.
It gives the right of ownership but is also known as risk capital (from the viewpoint of equity shareholders, since it does not offer the guaranteed return to an investor). Equity shareholders have a residual claim on the company’s income and assets. Due to high risk, investors’ expectation of a return from business is also high.
Big or established companies generally take the route of Initial Public Offer (IPO), the primary market for equity financing. However, private businesses or new businesses take the way of private equity or venture capital.
Other than share capital, the remaining part of the owner’s equity is retained earnings. A company may also depend on such reserves for financing. Retained earnings are the cumulative net earnings of a company since its inception, less the dividend paid and drawings made. Also, the quantum of this reserve depends on future dividend decisions.
Options like preference shares are classified as hybrid finance, which has equity and debt characteristics. However, this kind of financing is not very popular with businesses.
One can raise this source of finance with the help of the following:
- Term Loan: This refers to secured Borrowing from banks and other financial institution
- Debenture Capital:It refers to secured debt instruments and they carry a fixed obligation of interest and principal repayment to debenture holders.
- Deferred credit: Generally, it is provided by supplier of plant & machinery, raw material vendor etc by deferring the payment
- Incentive Sources: Financial support provided by Government and its agencies.
- Miscellaneous sources: Options other than above like unsecured loans; public deposits, leasing, and hire purchase are classified under this head.
Factors to Determine Right Source of Finance
So to choose the right sources of finance for the business, factors like cost, risk, control, and flexibility should be considered.
Cost of Finance
Every source of finance carries some cost with it, known as the cost of capital. While we talk about debt financing, other than lenders’ expectations, an advantage of tax deductibility indirectly lowers the cost of debt. The interest rate or coupon rate is the cost paid by the business for using the debt capital. When the comparison of cost takes place between the two sources, debt becomes a cheaper source of finance since the financial charges on debt are a tax-deductible expense, whereas dividend is not.
For e.g. If the Interest paid for long-term debt is 10% (D) and the tax rate is 50%(t), the effective cost of such debt to business is:
D (1-t) = 10(1-50%) = 5%
Risk Associated with Source of Finance
A business has exposure to various kinds of risks. These risks should be considered while deciding on the source of finance. E.g., if a firm relies majorly on debt financing, they are said to be highly leveraged as it bears a high financial risk. If debt repayments are not on time, this can lead to legal action, and hence there is a risk of bankruptcy. High financial leverage also affects the earning per share. So, for deciding on an optimal capital structure, a company should analyze the degree of leverage that it can tolerate.
Dilution of Control and Management
Controlling and management in the hands of the owner dilute with more and more equity introduced from outside of business. Promoters or owners who do not want to lose control of a business and prefer to keep significant decision-making in their hands will consider equity financing only to a certain level.
Flexibility in Repayment
It plays a vital role in deciding the capital structure. A firm functions in a dynamic business environment today. It should be able to respond to sudden shocks to its cash flows stream. A highly leveraged firm may face a cash shortage during adverse conditions, which may lead to the sale of assets etc., for the generation of cash. Also, in extreme cases, a firm may have to take a step of capital restructuring or even liquidation on the worst side.
Other than the crucial factors discussed above, some other factors also play a role in selecting sources of funds. Like, floatation cost, which is high in the case of equity. Similarly, regulatory rules of various bodies also need to adhere to. In the case of market listing (IPO), rules framed by respective legal bodies of different countries have to comply with. For instance, the legal body in the US is SEC and India is SEBI. Thus, it is essential to analyze the present and probable future situation of a business to choose the right source of finance.