Factors considered for choosing the right source of finance Cost of Finance, Attached Risk, Dilution of Control, and Flexibility of Repayment. Comparing various alternatives and evaluating them on the basis of these crucial factors helps in building 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 usage of finance, which is the lifeblood of any organization.
An efficient financial management calls for various kind of decision making. A major decision for any organization is to decide the sources for procurement of funds. Broadly, the category of finance available for any business is debt and equity. The proportion of financing from these two determines the capital structure of a business. 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 fund 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 combination to be used for raising fund, it is very important 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 company’s income and assets. Due to high risk, the expectation of return by investors 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 a route of private equity or venture capital.
Other than share capital, the remaining part of 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, in future, a quantum of this reserve depends on future dividend decisions.
Options like preference shares are classified as hybrid finance, which has characteristics of both equity and debt. However, this kind of financing is not very popular with businesses.
It can be raised with the help of:
- 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 while selecting the sources of finance for business factors like cost, risk, control, and flexibility should be taken into consideration.
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 expectation, 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 costs of two broad sources are compared, debt turns out to be a cheaper source of finance, since the financial charges on debt is 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 is exposed to various kinds of risks. These risks should be considered while deciding on the source of finance. For e.g. in case, a firm relies majorly on debt financing, then they are said to be highly leveraged as it bears the high financial risk. That is, if debt repayments are not made 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 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 the control of a business and prefer to keep major decision making in their hand will consider equity financing only up to certain level.
Flexibility in Repayment
It plays an important 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 the shortage of cash during adverse conditions, which may lead to the sale of assets etc for 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 the selection of sources of funds. Like, floatation cost, which is high in case of equity. Similarly, regulatory rules of various bodies also need to adhere. In a 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 important to analyze the present and future probable situation of business to choose right source of finance.