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BUSS 1601 Financial Management - Middle East College
Assuming that you are the financial manager of the company, what will your proposal is for the sources of finance?
Question 1. Identify five short term and five long term sources of finance.
Solution: Five Short Term Sources of Finance
1. Bank credit (i.e in terms of overdrafts, cash credits, loans and advances etc) - This is a facility extended by the bank to allow the company to draw money in excess of the balance from its account. The limit will be extended due to the worthiness of the company.
2. Trade credit - This refers to as a situation where the company allows its customers to place and receive orders of the goods without any immediate payment. It gives a fixed period of time (usually 30 to 90 days) of payment.
3. Customer advances - company can make an urgent request to loyal customers to make payment advances so that they can be delivered when goods will be available. This is a cheaper way if the company has royal customers who belief in the company.
4. Getting loans from cooperative societies-These are loans from institutions other than banks which may give the company funds to carry out the project. The terms are the same as that of the bank but, their interest rate are much lower as compared to banks.
5. Installment credits- customers will pay a small portion of money and company will charge interest for extending credit on the period of installments. This will be the agreement between the company and their customers on which periods will be viable to both of them.
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Five Long Term Sources of Finance
1. Retained earnings/internal accruals - The company can retain a portion of this 30 million to use in this project depending on its age (maturity) and dividend policy they have. It will strongly help in sorting out the financing issue.
2. Ordinary/equity shares- This will be the easiest source of finance that I can choose because it will represent the ownership of the company. The equity will be a prerequisite of the company and shareholders will not get a fixed dividend but only paid on the basis of the earnings of the company.
3. Term loan from commercial banks and government-This is a long term loan given by banks that will be repayable for a period of one to twenty years. This will give the company enough time to use the funds on its use and pay later on installments with interest.
4. Preference share capital-These are shares issued that has a potential claim over dividend and repayment of the capital. These shares do bear a fixed rate of return regardless company makes profit or not. The shareholders do not enjoy any voting rights as like equity shareholders.
5. Grant finance - These are funds obtained from government departments, foundations, trust, international institution and/or individual. The funds are usually non-refundable. The company may source these funds because it is a cheaper way to do if the option can work for the company.
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Question 2. Discuss the advantages and limitations of two short term and two long term sources of finance suitable for the given scenario.
Solution:
Discussion on two short term sources of finance
Bank Credit
Advantages:
1. The company will not require any collateral or security to acquire it. It can take the credit at any time and amount upon allotted themandcan repay as little as 2 days and as maximum as one year (GlobalCIMA/319.pdf). The will help the board to make a quick decision on the same.
2. They are more flexible the company and overdraft amount can be adjusted according to their needs. It will be subject to no restrictions to draw down funds for a wide variety of purposes the company's project intends to do (GlobalCIMA/319.pdf).
Limitations:
1. The company is likely to experience cash-flow problems if the bank decides to issue credit on a short notice. If you fail to repay as per date required will subject to more interest rates and penalty(GlobalCIMA/319.pdf).
2. Interest rates are usually variable and may end up being higher than the usual bank loan. Repaying it as soon as you are able to will be beneficial otherwise will attract daily charges(GlobalCIMA/319.pdf).
Trade Credit
Advantages:
1. Sales will increase because customers do not need to pay cash immediately after purchase but will pay within 30 days from date of purchase. This will help the company to raise funds at a shorter time and generate more revenue (Mclaney 2006).
2. There will be minimal cash outlay with regular sales. Incoming cash flow from these sales will help the company to make payments to its vendors in time (Mclaney 2006). Through trade credit there will be more cash outlay later that will help the company to raise funds for its current project.
Limitations:
1. It will subject to imposing penalty to late paying customers and it will be a serious hit to the affected customers whose moral of loyalty may go down(Mclaney 2006). Not all the customers may be serious or committed to helping the company to raising the funds. It may sometime be a risk move but the company may has no option to do so to raise funds.
2. Also, customers may lose trade credit privileges due to their habit of late payment thus lose relationship and start demanding immediate payments(Mclaney 2006). This may not be a good move but it may force the company to do so in order to curb with those serious customers.
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Discussion on two long term sources of finance
Long-Term Loan
Advantages:
1. It is flexible because the company will not be required to pay full amount if the bank demand it as in like overdraft. The bank will also not monitor on how you use the money so long as you may the repayment as required (Aidan Berry 2005). This becomes easier for the company to raise money very fast and repay back on agreed terms, both interest rate and time period of less than one year.
2. In terms of loan interest, long term loans are the cheapest because of tax benefits. The interest the company will be paying will be a tax deductible expense hence it will be cost effective (Aidan Berry 2005). The company will at the end will pay low tax to authority.
Limitations:
1. Irregular repayment amount - Once you get a loan with irregular repayment amount or a variable interest rate, this makes it difficult to determine the exact amount of future repayments. Consequently, it will become challenging when it comes to financial planning (Aidan Berry 2005).
2. Sometimes there can be a repayment burden if those who fall behind economical times, the assets of the company will be seized. So the repayment burden becomes a limitation as opposed to equity financing because shareholders do not require repayment, instead they require dividends on profits the company makes(Aidan Berry 2005).
Ordinary/Equity share capital
Advantages:
1. Equity capital can serve as permanent capital because it can only be repaid at a time of liquidation if arises. As it stands out last in the list of claim, it will provide a cushion to their creditors only at a time of winding up the company (Mclaney 2006). Therefore the finance manager will take the option because it will not have the burden of repaying it back as like loan finance.
2. The company will raise money through equity issue without even creating any charge to the company assets. Therefore, they are free to be mortgaged for borrowing if need arises (Mclaney 2006). This will be a better option for the finance director to take in order to raise the funds.
Limitations:
1. Investors who want steady income will not prefer the company to issue equity shares because of fluctuation of return due to fluctuations of market share price(Mclaney 2006). The board of directors will at a fix when it comes to dividend decision to their shareholders.
2. The cost of equity share is likely to be generally more expensive as compared or opposed to cost of raising other sources of finance like loan or debentures (Mclaney 2006).
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