Sources of Funds and Capital Structure - Research Paper Example

? SOURCES OF FUNDS AND CAPITAL STRUCTURE Table of Contents Sources of Funds 3 Short term sources of raising funds 3 Hire purchase 3 Leasing 3 Long term sources of funds 4 Equity Shares 4 Preference shares 5 Debentures 5 Bank loans 5 Capital Structure 6 Equity Financing 6 Debt financing 6 Works cited 8 Name of the Student: Name of the Professor: Name of the Course: Date: Sources of Funds Short term sources of raising funds Just after the establishment of any business, there are funds required for meeting regular expenses (for example- raw materials needed to be purchased in regular intervals, employee wages required to be paid, payment of water charges in regular interval etc). These requirements are generally met by means of short term sources of financing. Sources of short term funding Hire purchase It is an instalment credit where the hire purchaser or the hirer takes different goods on the basis of hire at a predetermined rental rate (including the principal as well as the interest amount the option of such purchase). In this type of funding, the hire purchaser or hirer receives the property or good instantaneously after signing the purchase agreement. However, the ownership gets transferred fully after finishing the last instalment payment. Leasing The procedure of lease financing includes procurement of various assets by means of taking lease. Lease means one contract in which the ownership, the funding linked with the asset or the equipment and the risk taking are totally separated and shared by two or greater than two parties. In case of lease financing the lessor finances and the lessee accepts the risk, involved by utilization of the asset or equipment taken on lease, whereas a third party actually owns it. Another alternative way is that the lessor would own as well as finance the asset or equipment, whereas the lessee would enjoy using it along with bearing certain amount of risk. This type of transaction includes commercial arrangement in which the equipment owner possesses the right to the asset or equipment user for utilising it in return of fixed rental. Long term sources of funds Long term sources of raising funds mainly include those sources which are needed for longer span of time. These types of financing activities are mainly associated with fund expansion projects. These projects are complex in nature and need huge sources for the funding activities. It is because of this reason that the organizations use long term sources for raising the funds. In many cases, the organizations do not make use of one single source of financing. The main long term sources of raising funds are: Equity Shares The equity shares form an essential part while considering the ownership of any particular company (Walter 3). When any business decides to expand its operation, it issues high number of shares, in order to raise the fund needed for effective implementation of the desired plan. This type of investment is an important source of raising the funds and it provides the investors with a certain portion of company’s profit along with taking part in taking company’s decisions (Hafer and Hein 15). This strategy of rising the funding by an organization out-performs all other strategies (Fontanills and Gentile 1; Rosen 8). When the earnings of a company are high, the stock prices increase resulting in higher profitability for the company as well as the investors. If the company originates from growing market then raising of fund by issuing its equity shares turns out to be highly profitable. However, when there is economic downturn the shares of the companies remain at high risk in spite of their high brand value and strong management. Preference shares Issue of preference shares is another way of raising fund where the dividends are payable on the shares at the fixed rate and paid only in case of earning of profit by them. Thus, there remains no obligatory burden for the company (“Methods of Raising Capital”). But these shares do not possess voting rights. Debentures The companies have power of borrowing or raising loans by means of issuance of debentures where the interest rate payable on such debentures remain fixed in the initial time of issuing and recovered by charging asset or property of those companies as they provide security for such payments. The companies are liable for paying the interest amount even if no profit has been earned. Debentures are issued for financing or funding the long term requirements but without carrying any voting rights for the investors. Bank loans Bank Loans are mainly long term financial loans, which are taken from commercial money lenders. The loans are taken for specific purposes holding some particular reason (for example- car loan, personal loan, home loan etc). These loans are taken on a predetermined time period and have interest rate attached with it. Utilization of bank loans is quite easy for the businesses in order to raise funds. However, the total cost of repayment of these loans along with additional interest payment becomes very high. Capital Structure The capital structure means the way by which a corporation finances the assets by means of equity or debt or a combination of both. The capital structure of a firm refers to composition of its liabilities. The capital structure plays an important role while making financing decisions. Choosing proper capital structure is very important for the purpose of making effective financing decisions. It is the extent to which internal and external sources of financing should be done for financing the business activities. A firm should finance its business activities by planning an appropriate capital structure involving minimum risk and maximum profit. Equity Financing Equity financing is a means of funding the company’s requirements through internal sources (Chandra 16.2). Selling of common stock or preferred stock involves reduced risk for the companies. The main advantage lying in case of equity financing is that the company does not have the obligation of repaying the money (Fleming 62; Chiste 119). The inclusion of high profiled investors also helps in increasing the credibility of the businesses. The owners can raise the portion of equity financing by making more investment in the company from the internal sources. Debt financing Debt financing takes place in the form of various loans which are required to be repaid in specified time along with an additional interest. The debt financing can be for short term period of one year or long term period of more than year (Manresa 69). Debt financing helps in gaining tax advantages as the interest payments made on the loan amounts are generally deductible. The debt financing has its own disadvantages as well. This type of financing includes high risk because it becomes difficult for the businesses to repay the loan amount, when there is irregular cash flow (Seidman 32). Every company should keep on assessing their debt to total capital ratio in fixed interval of time for finding the actual proportion of debt in total financing. It is calculated as: Debt to capital ratio = Debt/ (Equity + debt) As stated above, it is easy to get bank loans for funding business activities. But the total cost involved in servicing the loan amount becomes so high that it becomes difficult for the companies in repaying such loans. In case if the proportion of debt is higher in the total capital structure then the organizations should take immediate steps for reducing the debt proportion by repaying back the loans or other liabilities. It is known that increase in debt proportion increases volatility and gradually the entire scenario turns out to be very risky. It is always safer for the organizations to increase their internal sources of financing in order to include lesser risk in their financing process. Works cited Chandra, Prasanna. Fundamentals of Financial Management. New Delhi: Tata McGraw-Hill Education, 2005. Print. Chiste, Katherine B. Aboriginal Small Business and Entrepreneurship in Canada. Canada: Captus Press, 1996. Print. Fleming, Louise. Excel HSC Business Studies. Singapore: Pascal Press, 2004. Print. Fontanills, George A., and Tom Gentile. The Stock Market Course. New Jersey: John Wiley & Sons, 2002. Print. Hafer, Rik, and Scott Hein. The Stock Market. Connecticut: Greenwood Publishing Group, 2007. Print. Manresa, Maritza. How to Open and Operate a Financially Successful Import Export Business: With Companion CD-ROM. Florida: Atlantic Publishing Company, 2010. Print. “Methods of Raising Capital” Business.Gov.in. Business Knowledge Resource, 2013. Web. 20 August 2013. Rosen, Kenneth D. Investing in Income Properties: The Big Six Formula for Achieving Wealth in Real Estate. New Jersey: John Wiley & Sons, 2008. Print. Seidman, Karl F. Economic Development Finance. London: SAGE, 2005. Print. Walter, Robert William. Financing Your Small Business. New York: Barron's Educational Series, 2004. Print. Read More