MODULE BUSINESS FINANCE

CHAPTER 3
SOURCES OF CAPITAL

Learning Objectives:
1. Enumerate the sources of capital
2 . Classify the forms and classes of stocks
3. Appreciate the Importance of Debt Financing - Borrowings
4. Differentiate Equity versus Debt Financing
5. Apply the principles and concept on Loan and
Amortization

Equity – are the financial resources provided by owners of the business, including the
initial, additional investments and earnings retained in the business.
This amount is the difference between total assets and total liabilities.
Borrowed Capital - are those loans extended by financial intermediaries or investors,
in the issuance of credit instruments.

Owner’s Equity – is the amount provided by the owner.

Sole Proprietorship:
Owner’s Equity:
Beta, Capital, January 1, 20CC P20,000
Add: Net Income, 20BB 10,000
P30,000
Less: Drawings 5,000
Beta, Capital, December 20CC P25,000

Partners’ Equity – amount provided by partners.

Partnership:
Partners’ Equity:
Andrew P120,000
Ariel 200,000
Manny 100,000
P420,000
Stockholders’ Equity – amount provided by corporation.
Corporation:
Stockholders’ Equity:
Contributed Capital

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12% Preferred, Non participating

Authorized 40,000 shares
Par value Php100
Issued 22,000 shares P2,200,000
Common Stock
Authorized 50,000 shares
Par value Php50.00
Issued 40,000 shares 2,000,000
Total Contributed Capital P4,200,000
Retained Earnings
Appropriated for:
Plant expansion P1,000,000
Un-appropriated 3,000,000 4,000,000
Total Stockholders’ Equity P8,200,000

By issuing ordinary shares to raise equity, the following are the advantages:

 A company is not required to pay dividends to ordinary shareholders – payment

of dividends is at the discretion of directors.
 Ordinary shares do not have maturity date which means that the issuing
company has no obligation to redeem them.
 The higher the proportion of equity in a company’s capital structure, the lower
the risk that creditors will suffer losses as a result of the borrower experiencing
financial duty.

DISADVANTAGE OF EQUITY

If a company issues more ordinary shares to raise capital, existing

shareholders will have to either outlay additional cash or suffer some dilution of
their ownership and control of the company.

FORMS OF CAPITAL STOCK

Authorized Capital Stock – is the maximum number of shares that the business
owners are allowed to issue.
Issued Stock – is the amount of authorized stock subscribed to and paid for in cash,
property or services.

Reacquired Stocks – these stocks can be reacquired in two ways:

 By gift from stockholders

 By buying back some of the company’s issued stock

Outstanding Stock – is the portion of issued stock nor reacquired.

Financial managers should also understand the contractual provisions of the

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stock forms for the following reasons:

 Stocks is authorized and issued on the basis of shares.

 Stock is reacquired by the business in terms of shares.
 Stock is voted on the basis of shares.
 Profits are calculated on the basis of shares.
 Dividends are declared on the basis of shares.
 Stocks purchase rights are distributed on the basis of outstanding shares.
 Assets are distributed in liquidation on the basis of shares.

CLASSES OF STOCK

1. Common shares are units of ownership registered

in the names of the proprietors. Rights and
limitation of shares are:

 The right to vote or elect the board

of the directors of a corporation at the annual stockholder’s meeting.

 The right to share profits and dividends as residual claimants after

preferred shares; and when management decides to pay dividends.

 Pre-emptive common law right on issuance of common stock before

selling to the public. Common stockholders are given stock purchase
rights, by subscribing to new shares before offering to public.

 The right to assets in liquidation, where right is pro-rata based, during

voluntary or force liquidation.

2. Preferred shares issuance is indicated in the articles of incorporation. Rights and

limitations of preferred stockholders are:

 No right to vote, right to elect is taken away for this class of stock.

 The right to share in profits and dividends. Preferred stockholders do

not share profits and dividends as residual owners. They are paid
prior to common shares, and as long as preferred dividends unpaid,
dividends cannot be paid on common stocks.

DEBT FINANCING – BORROWINGS

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The range of sources of debt to choose from is generally related to the size
of the business. A small business will have a relationship with one bank and will rely on
that bank for most or all of its debt finance. Large companies are not restricted to
borrowing from financial intermediaries and can also issue securities such as bills of
exchange.

Debts can be classified as current or short-term, non-current or long-term,

marketable and non-marketable debts. Current or short-term debts are debts due for
repayment within a period of twelve (12) months. A debt with a maturity term of more
than twelve (12) months is classified as non-current or long-term. A debt is secured
when the creditor has claims against the borrower and against assets of the borrower.
When debt is unsecured, the lender has a claim against the borrower but no additional
claim to any particular property owned by the borrower. Marketable debt are securities
such as notes, bonds or debentures which are issued to investors and can be traded in
a secondary market, thus, the ownership of marketable debt is transferable. Non-
marketable debt takes the form of loans arranged privately between two parties
where the lender is usually a bank or other financial intermediary.

Financial leverage is the use of borrowed capital while interest is the cost of
borrowed capital. The interest rate applicable to debt may be fixed or variable
(floating). Interest is deductible for income tax purposes, and the tax benefit is
considered an adjustment to interest expense for determining the cost of borrowed
capital. The formula:

Cost of borrowed capital = interest x (1-tax rate)

For example: ABC Corporation obtained a loan of P800,000 for a term of one year from
RFC Financing Corp. at 20% interest. Rate of income tax is 35%.

Cost of borrowed capital = 20% x (1-35%)

= .20 x (.65)
= .13 or 13%
Interest of 20% on P800,000 = P160,000
Tax benefit @35% of P160,000 = 56,000
Interest expense net of tax benefit = P104,000
Percentage (P104,000/800,000) = 13%

EXTERNAL SHORT-TERM FINANCING: AN ASSESSMENT

External financing refers to a rather limited and specialized area in financial

decision concerned primarily with bringing funds into the business. Liquidity is the most
important policy consideration of most businesses in considering short-term financing.
It is measured by the percentage of cash secured on the face value of the debt. Default
on payment of the principal and the interest, called solvency risk factor, is another
primary risk of short-term financing. Solvency risks increase as the total volume of
short-term financing increases. Another factor to consider is profitability, which is

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measured in terms of opportunity cost, and financial expenses such as service

charges, interest charges and carrying charges.

MAJOR SOURCES OF FUNDS

1. Trade Credit Market - is any place where raw materials or finished inventories may
be purchased on credit. Manufacturers and distributors from all over the country
and other nations are supply sources. The following are important supply factors to
consider:
 Total quantity of credit available
 Inventory supply services
 Financial expenses
 Repayment terms
 External controls
2. Customer Loan Market - is any place where cash funds can be negotiated. Supply
sources are commercial banks, commercial paper companies or discount houses,
non-banks discounting unsecured promissory notes to mature in 4 to 6 months of
date of issue; and commercial finance companies. Financial managers are
concerned with the following in negotiating for loans:
 Quantity of cash available
 Cash and other related financial services
 Expenses for financing
 Repayment terms
 Degree of control exercised over the borrower
3. Receivables Sales Market - Factoring companies buy outright from manufacturers
their open account receivables. No liability is created on the books of the business
when receivables are sold to a factor because this is not considered a borrowing.
EQUITY versus DEBT FINANCING:
Invested Capital Against Borrowed Capital

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If the rate of return is higher than its cost, it is advisable to use borrowed
capital. For example, ABC Corporation is intending to invest P1M for a project with an
expected rate of return of 25%. Loans available at an interest rate of 16% per annum,
and tax rate is 35%.

Cost of borrowed capital = 16% (1-35%)

= .16 x .65
= .104 or 10.4%

From the illustration, the cost of borrowed capital will result in an income of
14.6%; that is 25% rate of return from the project 10.4% cost of borrowed capital.

LOANS AND AMORTIZATION

Some provisions have to be made for repayment of the principal, whenever

a creditor extends a loan. It might be repaid in equal installments, or it might be repaid
in a single lump sum. The mode of payment of principal and interest will depend on the
agreement of both parties.

Basic Types of Loans

 Pure Discount Loan - is the simplest form of loan. The debtor

receives money today and repays a single lump sum at some other
time in the future. A one-year, 10% discount loan, would require the
debtor to repay Php1.10 in one year for every peso borrowed today.

Treasury bills are pure discount loans.

 Interest Only Loans - allows the debtor to pay interest in each

period and to repay the principal at some point of time. With a three-
year, 10%, interest-only loan of Php10,000, the debtor would pay
Php10,000 x .10 = Php1,000 per interest at the end of the first and
second years. At the end of the third year, the borrower would return
the Php10,000 along with another Php1,000 in interest for that year.

 Amortized Loans - requires the debtor to repay parts of the loan

amount over time the debtor pays interest for each period plus fixed
amount. The process provides loan payments on regular principal
reductions. For example a business takes out Php50,000, five-year
loan at 9%. The debtor would pay the interest on the loan balance
each year and reduce the loan balance each year by Php10,000.

Below is the illustration:

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Year Beginning Principal Interest Total Ending

Balance Paid Paid Payment Balance
1 Php 50,000 10,000 4,500 14,500 40,000
2 40,000 10,000 3,600 13,600 30,000
3 30,000 10,000 2,700 12,700 20,000
4 20,000 10,000 1,800 11,800 10,000
5 10,000 10,000 900 10,900 0
Total 50,000 13,500 63,500

For further discussion, please refer to the link provided: Sources of capital
https://www.youtube.com/watch?v=F1-8BAOXoJo
For further discussion, please refer to the link provided: Debt Financing-
borrowing
https://www.youtube.com/watch?v=fH_gQmiVZgU

Reference:

Basic Business Finance: Management Approach, 2 nd ed., Ruby F. Alminar-Mutya, DBA

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