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Table of contents Introduction 7 Content 8 1. Identify and describe the various source of finance available to business 8 1.1 Short term sources of finance 8 1.1.1 Bank loan 8 1.1.2 Overdraft facilities 9 1.1.3 Trade credit 9 1.1.4 Leasing: 9 1.2 Long term sources of finance: 10 1.2.1 Owners’ capital: 10 1.2.2 Shares: 10 1.2.3 Venture capital: 11 2. Assess the implications of the different sources of finance to business related to risk, legal, financial and dilution of control and bankruptcy: 12 2.1 Issued of debts: 12 2.2 Issued of equity: 13 3. Select appropriate sources of finance for Vale Filers and make recommendations on the best ways of raising finance: 15 4. Assess and compare various costs involved with each sources of finance to Vale Filters: 17 5. Prepare the cash budget for Vale Filters and discuss the importance of financial planning: 19 Conclusion 21 Preferences 21 Introduction Vale Filters is the new business, which produce and sell the new filter in the market. It is owned by Alan Simpson and his colleague Geoff. To help company exist and develop in business market, it is very important to understand the different sources of finance. Since then choose the suitable sources which suitable for the company situation. Vale Filters is still new company but over recent year, it intends to expand into national and international market. To expand the business, the most important thing is know the advantages and disadvantages of different sources of finance to support the best way to increase own capital. Therefore, this report will identify and describe the various sources of finance available to Vale Filters as well as the implications of these different sources of finance in order to make recommendations on the best way of raising finance. Moreover, this report also makes clear their costs, and explaining the importance of financial planning and also analyzing some problems which may occur in a cash budget. Content 1. Identify and describe the various source of finance available to business: It can be sure that when people intend to start up their own business or they want to expand their existing business, they will think about the money, which they need to carry out their plans. This money is called business finance. In general, there are many various sources of finance which can divided into two parts: short term sources of finance and long term sources of finance in the form of debt on which interest paid or equity capital on which dividends are paid available for sole traders, partnerships, and companies (private limited company and public limited company). 1.1 Short term sources of finance: Short-term sources of finance are used to business activities in the short term that are usually going to last less than one year. There are some kinds of short-term sources of finance in the form of debts such as bank loans, overdraft facilities, trade credit and leasing. 1.1.1 Bank loan: With business, bank loan is one of the most useful sources of finance. It is very flexible and the business can be used it for short term or long term. Bank loans that are less than one year can be considered as short-term source of finance. It is similar to another loans, borrowers must be pay interest on their debts and depend on many factors such as the amount of money which they borrow, how long they borrow and so on, it can be expensive and also can change. 1.1.2 Overdraft facilities: Nowadays, most businesses have bank accounts. When the businesses need money immediately, for example, they need money to pay for purchases but they do not have enough money in their bank accounts, they can negotiate with the bank for an overdraft. In general, an overdraft is an agreement with a bank to allow the business to spend more money that they have in fact. It means they can use the money they do not have in bank account. It is considered a form of loan to help businesses solve their finance problems fast but it is very short term loan so they must repaid as soon as money is out into the account and pay interest on the money they overdraft. The interest rate on an overdraft can be quite high, especially for small firms. 1.1.3 Trade credit: Trade credit is the method that the businesses do not need to pay money immediately. They have been to give a period of time (usually between 28 to 90 days) to pay for goods that they have received. If the businesses pay money in this period time which have been to give, they do not have pay interest on debt but after this period, “the supplier might charge a fee or start charging interest”. It is the favor which suppliers give to buyers to remain close relationship in the long term. “This gives the business the time to be able to manage their finances and balance their cash flows more effectively”. However, the suppliers will meet difficulties if they are not received money for the goods from the buyers. 1.1.4 Leasing: Equipment and machinery are necessary for most businesses and almost them need to buy equipment and machinery. In fact, there are many ways to buy them and leasing is one of the useful methods. A lease means that the business is paying for the use of a product but do not own it. The business hires the assets from leasing company and pays a monthly rental change for it. It can be seen likely “hiring”. This method has many advantages such as cheaper in the short term than buying, easy to update, easier to manage the cash flow. However, it costs very much when using this source in long term. 1.2 Long term sources of finance: Long-term sources of finance are finance that need in a long time and may be paid back after many years or not at all. With a company has many kind of long-term finance such as owners’ capital, shares (ordinary shares, preference shares) in the form of equity; venture capital and others in the form of debt. 1.2.1 Owners’ capital: When people intend to set up their business, they always have some own money to invest. This money is called “owners’ capital”. This money may be the result of saving, borrow from relatives and so on. This has the advantages that it does not carry with it any interest and the money can be repaid at leisure. 1.2.2 Shares: The company can increase finance by shares. In fact, there are two kinds of share: ordinary shares and preference shares. ( Ordinary shares: • Issue new share: Ordinary shares are shares which company sells to the public and anyone could buy the shares. “The ordinary shareholders are the owners of the company”. The dividend they receive depends on the profits made by the firm so this value can fluctuate significantly. Therefore, it is risky investment. However, the shares will give the holder the right to vote on corporate issues such as board elections and corporate policy. • Retained profit: Retained profit is also useful source of finance to expand exist company. This source is the form of internal source. When the company has surplus funds, the management will use this money to invest in new projects to develop company instead of paying dividends for shareholders. ( Preference shares: Preference shares offer their owners preferences over ordinary shareholders. It means when company pay dividend, the people who own preference shares will receive dividend before ordinary shares. It brings a fixed rate of return for the investor so a preference share is a less risky investment than an ordinary share. However, the preference shares’ owners do not have a say in the business’s activities. 1.2.3 Venture capital: Venture capital is the source, which was invested by venture capitalists. They are groups of wealthy individuals or companies who invest in fast growing companies that they estimate potential and normally involved in business for long term growth. They usually not only invest big amount of money but also provide these companies that they invest some useful advices, contacts an experiences. It is so lucky for the company to find venture capital. However, it is not all companies can approach with venture capital because venture capitalists only invest in the business with highly rated prospects. Besides, the new business can wait the investment from business angels who want to give opportunities to new businesses but they usually can invest small amount of money. Another long-term source of finance is issue debt note such as bonds or debentures. Debenture is a type of fixed-interest security loans, issued by a company (as borrowers) in return for long-term investment fund. When the business issue debentures and people buy them, they will become debenture holders. Company has responsibility to pay interest for them before any dividend pay for shareholders. If a company makes a loss, it still has to pay for debenture holders interest charges. Because debentures are high risk, the company must also offer higher profit. In general, bond is similar to debenture. However, bond is issued not only by company but also by government and towards the public and pay fix interest to investors. Therefore, it is less risky but also less profit for investors. Besides, many sources of government grants are also made to help the businesses such as Regional Selective Assistance, The Small Loans Guarantee Scheme because government believes that successful businesses provide jobs for employees and create wealth for the country. 2. Assess the implications of the different sources of finance to business related to risk, legal, financial and dilution of control and bankruptcy: As can be seen from the text above, there are many sources of finance for company to choose but we must consider about elements related to risk, legal, financial and dilution of control and bankruptcy. 2.1 Issued of debts: First, the company must concern about tax implication. When issuing debt, the company has to pay tax after they pay interest for debt holders. Hence, issuing debt will reduce the profit chargeable to tax and increase company profit available for dividends. The effect here is they do not have pay tax on the interest from holding the debt when they receive profit, they must pay interest for debt holders first then pay corporate tax on remain money. When they use debt, the use of debt will increases the corporate tax shields and they have to pay an amount interest for bank or other sources. However, when using debt source, the existing shareholders’ stake would not be diluted because debt-holders do not have any voting right in company. It means when issuing more or less debts, the stake of the existing shareholders would not be reduced and the authority of Chief Executive Officer (CEO) as well as the management of company will be intact. With the debts, the company must have obligation to pay interest for debt holders. The interest is fixed by the debt holders and becomes the expense of the company. If company makes a loss, they still have to pay its interest charges. If they cannot pay interest, the debt holders will be become creditors. In this case, the company have to find method even sell their assets to repaid money to debt owners. If not, the company will be sued and the director of the company maybe goes to prison. Apart from cost of debt is normally much cheaper than the other costs such as cost of preference share, ordinary share, issue debt is also financial risk. “Large amounts of debt can lead to increased risks of bankruptcy” because debt owners can take control of the company if they do not receive their interest payment. Finally, because of Articles of Association, or the trust deeds of existing loan stock, there maybe legal restrictions on the company’s power to borrow. 2.2 Issued of equity: As we know, there are two kinds of share: ordinary shares and preference shares. When company issues ordinary shares, the company has to pay cost of ordinary shares when issuing new ordinary shares. This payment will be paid after tax so ordinary shares are non tax-deductible. In other words, the company issues shares will pay for corporate tax more than issues debts. The main point of company is net profit so company should consider about issue how many shares or debts to pay lowest tax and bring highest profit. With the preference shares, tax does not affect directly. Although when a company issues Preference shares, it needs to pay the cost of preference shares, this is paid out from the earnings after tax. Therefore, it is similar to ordinary shares, preference shares is non-tax deductible. As like as debt owner, the existing shareholders’ stake would not be diluted because the preference shares do not carry voting right so it will diluted the control of existing shareholders. Therefore, the authority of Chairman is not be affected. However, it is not similar to debt owners and preference shareholders. In the stock market, each ordinary share has one vote. It means that the shares will give the holder the right to vote on company issues such as board elections, plan of company, company policy and so on. Therefore, it will influence the control of the Chairman. When the company issues new ordinary shares, the percentage of stake of the Chairman will reduce. In this company, if Alan wants to have majority control, he must have more than 50 percent of company’s stock. Therefore, when company issues new shares, he must consider carefully about how many shares he will keep avoiding the dilution of control. In other words, he must ensure the percent of shares he hold when company issue new shares are still more than 50 percent because the more stake the shareholders hold, the more control of the company they have. With legal implication, the company has the obligation to pay the dividend for shareholders including preference shareholders and ordinary shareholders. The preference will be received the fixed rate of dividend and preference dividends must be paid before any ordinary can be paid. On the other hand, the dividend ordinary shareholders receive depends on the profits made by the firm so it is more risky than preference share. With ordinary shares, the company do not have dividend to pay, the market value of the shares will be fail. As a result, the value of company will be fail and no one wants to buy the shares. Company will meet difficult to mobilize funds. About the risk implication, the preference shareholders have lowers risk than ordinary shareholders. The preference not only receive fix rate of dividend, receive dividend before ordinary shareholders but also when the company goes bankrupt, they have the right to receive money from the sales of fixed assets of the company prior to the ordinary shareholders. Moreover, when the company issues new ordinary shares, the dividends of the existing ordinary shareholders will decrease unless they buy more new ordinary shares because the number of ordinary shares increase, the dividends per share decreases. In addition, when company goes bankrupt, they can only receive money from selling company’s asset after debt owner and preference shareholders. As regard the financial implication, the factors that influence the cost of preference shares are flotation cost and preference share price. The dividend does not affect the cost because it is fixed. On the other hand, the factors that influence the cost of ordinary shares are flotation cost, the dividend payment, and the growth rate. 3. Select appropriate sources of finance for Vale Filers and make recommendations on the best ways of raising finance: There are many sources of finance for company to choose but how to choose suitable source for company’s situation is not easy. Choosing finance source affect strongly to company. The company will be successful if it has suitable finance but it will be failure if unreasonable finance sources were applied. Therefore, it will consider carefully all aspects before choosing the source of finance for company because one source can suitable for company at that time but can not be sure that it will suitable for the company in another moment. At the first time, Vale Filters is still young company; it will need to raise capital by safe finance source. Owner’s capital plus bank loan is good option for Vale Filters in this case. Using their private capital is the safest method to raise company because it does not cost any expense. In addition, Alan and Geoff know six other people interest in investing in the new business. It is very useful to use this angel capital to develop company. They are very lucky because in fact, it is not easy to find these angel capitalists. However, to start up and expense business, it will need a lot of money. Although it is best choice and have most advantages, it will be not enough to depend on only their private capital, they have to approach another sources and bank loan is the second good choice. It is a simple source of finance and easy to get, but the cost we must incur is high interest and the bank usually require mortgage. We must pay interest for bank, so our profit must be use to pay for them. The company must have used partly their profit to pay interest for bank loan. As a result, it is not good for their business if they have low profit. Moreover, if the company cannot pay the interest, they can lose their mortgage that they use to borrow. However, every method has advantages and disadvantages and the risk of bank loan can be accepted for the new company because it is quite save and cheaper than the other sources of finance. In addition, in fact, if the company cannot pay interest and loan on time, the bank usually consider carefully to give company more time to pay because they know when company go bankrupt, they can receive all of their loan which they lend even they hold their mortgage and it will affect to many other problems. Moreover, over recent time, Alan intend to expand business into national and international market. Therefore, they will need purchase more machine and equipment. According to theory above, using leasing is probably the most reasonable and efficient way in this case. First, the company can reduce the capital requirement in purchasing machinery. In addition, the machines can be up-to-date because the lessee can change the machines to the newer model after the end of one leasing period. Furthermore, leasing rate is fixed over the term similar to the bank loan, thus it is convenient for budgeting the cash flow. However, it is difficult to repaid equipment that they lease before the end of the leasing term. Hence, the company has to continue to pay even though the machine is no longer needed. Therefore, the company also consider carefully before making decision because in some case, it is more expensive than purchasing machine. When start up company and at the first time of the company, the company should use the sources of finance that were suggest above to raise capital and develop gradually. After period of time, when company become stronger and have situation in the market, issuing debts, issuing shares (preference shares and ordinary shares) are the good options to help company raise finance to expand its business. The reason is the big company will attract investors easier than smaller company because “the high standing of such companies makes investors and other creditors more willing to offer finance/credit”. In addition, the big company is more willing to raise capital by this way because issue debt and issue share can help company raise capital very much but they are very risky. In general, it provides a new finance that is suitable for raising large capital because if the company issues share, it will attract a lot of investment. Moreover, cost of debts is normally cheaper than costs of issue shares because cost of debt is normally the interest paid before tax, which will set against taxable profit. Although costs of issue shares are higher than cost of debts, the company must pay dividend to shareholders and issuing new shares may provide the risk of reducing the control of existing shareholders, it is still a good way to raise capital in order to develop company Finally, beside these resources above, when company becomes strong company, they can use retained profit from issue debs and issue shares. It is a useful method to raise capital. Its cost is cheaper than ordinary cost because the retained earnings do not need to pay the flotation cost and it is easier to use this source because it is the dividend of shareholder that the company intend to pay and the company can use this money to invest in new project with the agreement of shareholders. 4. Assess and compare various costs involved with each sources of finance to Vale Filters: When the company intent to use one of finance source, they need to concern about the cost of finance of this source to have suitable choice. In general, cost of finance is the cost when you use the money of other people. Therefore, it can be consider that cost of debt is interest and cost of equity is dividend. Alan and Geoff have three methods of finance and the cost of finance of each source is shown as follow: Option1: |Source of finance |Cost of finance |Weightag |WACC | |Equity |15% |100% |15% | | |Cost of capital | |= 15% | Option 2: |Source of finance |Cost of finance |Weightag |WACC | |Bank loan |10% |70% |= 7% | |Equity |15% |30% |= 4.5% | | |Cost of capital | |= 11.5% | Option 3: |Source of finance |Cost of finance |Weightag |WACC | |Equity |15% |35.92% |= 5.388% | |Bank loan |10% |35.92% |= 3.592% | |Government loan |5% |28.16% |= 1.408% | | |Cost of capital | |= 10.388% | According to the table above, we can see that in option 1, Alan and Geoff use only the source of finance is equity. Moreover, in option 2 beside equity, they use bank loan more and in the last option, they combine equity, bank loan as well as government loan and the last option can be considered the best way to raise capital for Vale Filters. First, we must care about the various costs which issue shares and debts including bank loan and government loan must be incurred. According to the table above, it can easily to see that the WACC of the option 3 is shortest. It means using this cost, the company will pay money for the cost of finance shortest. Moreover, with ordinary shares, they must pay tax before they pay dividend for shareholders. With bank loan and government loan, they do not need to pay tax. With ordinary shares, the main cost is dividend. Another cost is when they issue shares they must pay the cost of providing shareholders or owners to know information about the performance of the business. With loan of bank and government, interest rate is the main cost. Secondly, the interest rate of loan is fixed so they will know exactly how much interest they must be pay for bank and government. Therefore, they will have a plan to mobilize funs. However, with shareholders, they must use all their profit to pay dividend for them so it is difficult to have exactly plan. Thirdly, when the company makes loss and bankrupt, the bank will hold all its asset which they use to be mortgage. However, if they do business lose, they do not need pay anything for shareholders. Overall, to reduce the money pay for tax and risk of bankruptcy we should mix of financing debt and equity. It is the best way for Vale Filters. 5. Prepare the cash budget for Vale Filters and discuss the importance of financial planning: A good financial planning plays an important role in preparing for a business success. It helps the company control the money inflows and out flow efficiently. Therefore, the company can use the money more efficiently and forecast the problems that may occur in the future in order to solve these problems. Therefore, the company needs to prepare cash budget. The cash budget of Vale Filters is supposed to show the cash receive and cash payment. Working capital is used manage day-to-day operation and company manages working capital by maintaining optimum level of inventory, receivable and cash. Manage working capital well, the company can control the money inflows and outflows to avoid bankruptcy and make decision expanding. In general, cash shortages and cash surpluses are popular cash flow problems. Both of them will affect not good to the company. Cash shortages is the phenomenon show that the company is making loss. They do not have enough money to pay expense of company for example employees’ salary, purchase and so on. To solve this problem, the company must has way to raise capital as well as control the cash flow of the company. In contrast, cash surplus is the problem of inefficient using capital. Cash surpluses will affect to opportunity cost of the company and it shows company is in obstructed situation. Moreover, cash surplus mean company hold stagnated money and this money is not be use so it can not make profit. It will affect to company’s develop. Apart from the problem of cash shortage and cash surplus, various implication of failure like overtrading can occur at that time. “Overtrading is a situation where there is an increased sales on credit being made with receivable rising and difficulty in finding cash to pay suppliers, wages and expenses”. In theory, overtrading happens when company want to obtain quickly turnover so in the short time “it tries to do too much with little long term financing”. This problem expresses by the symptoms as “the rapid increase in turnover, small growth in capital and high lever of current ratio” . There are some indicators must be look out for overtrading: “Deterioration in quick ratio and current ratio, overdraft at or near its limit, increase in trade payable, increase in sales revenues and trade receivables. Cash budget of Vale Filters |  |January |February |March | |1. Cash Inflows |  |  |  | | Sales |0 |50,000 |50,000 | |Total inflow(1) |0 |50,000 |50,000 | |  | | | | |2. Cash Outflows | | | | |Purchases (40% of sales) |20,000 |20,000 |20,000 | |Employees’ salary |20,000 |20,000 |20,000 | |Other operating business |25,000 |25,000 |25,000 | |Purchasing small factory |100,000 |- |- | |Machinery costing |150,000 |- |- | |Interest of bank loan |3,107 |3,107 |3,107 | |Loan payment |2,071 |2,071 |2,071 | |Total outflows(2) |320,178 |70,178 |70,178 | |  | | | | |Net cash flow: (1)-(2) |(320,178) |(20,178) |(20,178) | |  | | | | |(+)Opening balance |494,000 |173,822 |153,644 | |= Closing balance |173,822 |153,644 |133,466 | Conclusion To sum up, this report has provided the perspective of source of finance through identifying various different sources of finance, their implications, since then give recommendation to find the best way of raising company for Vale Filters. Moreover, it identifies various costs of each source and explain the importance of financial planning and cash flow forecast References • Edexcel, (2004), Managing Financial Resources and Decisions. First edition. BPP Professional Education, London • Ross, S.A., Westerfield, R.W., and Jaffe, J.F., (2005), Corporate finance, 7th edition, McGraw-Hill and Irwin • Biz/ed(2009), Long terms sources of finance, [Online]. Available from http://www.bized.co.uk/educators/level2/finance/activity/sources13.htm [accessed: 12 November 2009] • Biz/ed(2009), sources of finance for business, [Online]. Available from http://www.bized.co.uk/educators/level2/finance/lesson/sources1.htm [accessed: 12 November 2009]