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Sources of Capital
CHAPTER 3

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Table of contents

01 02
Sources of finance Classes of Stock
EQUITY –
Common shares
Forms of Capital Stock
Preferred shares

03 04
Financing Major Sources of Funds
Debt financing – borrowings Equity vs. Debt financing: invested
External short-term financing: an capital vs. borrowed capital
assessment Loans and amortization

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Why do new firms need finance?

Why do new firms need finance?

New businesses need finance to:
• buy or rent premises and equipment, pay for insurance,
promotion and initial stock in order to begin trading (known as
start-up costs)
• pay running costs — power, telephone, wages, more stock etc. —
until cash inflow is sufficient to do so
Many new businesses sell on credit to their customers in order to attract
sales.
The gap between having to pay for supplies and receiving payment for
sales can lead to business failure unless the business is sufficiently
financed.

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Why do existing firms need finance?

Why do existing firms need finance?

Established firms may require additional funds to:
•finance growth — as orders increase, more stock will need to be
purchased, more staff may need to be taken on and equipment and
machinery hired or bought. The firm may even need to move to larger
premises
•deal with late payment — selling to customers on credit can cause cash
flow problems unless payment is not received when due
•cope with a change in market conditions — a fall in demand due to
increased competition or an economic downturn can also lead to a
deterioration in cash flow.

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Internal sources of finance

B
Internal finance refers to Managing cash flow by reducing
the funds generated from the length of time that
within the business itself – customers have to pay invoices,
for example: while taking longer to pay
suppliers.

A C
Selling off fixed assets, Retained profit: the difference
such as machinery or between the revenue generated
premises. Such assets can from sales and costs incurred in
be leased back from the making them, which can be
new owner if they are still invested back into the business.
needed by the business.

Relying on internal finance

Financing a business via internal sources may Retained profit may be too low
be desirable. As it is generated by the to meet the needs of new
business, it does not need to be repaid, nor businesses or those experiencing
does it involve paying interest or other a fall in sales.
charges.

Unfortunately it may not always be possible

for a business to fund its operations by
relying entirely on internal sources.

Late payment of invoices could

Small or new firms may have little choice but
damage relations with suppliers and
to offer generous credit periods in order to
even lead to legal action.
win customers.

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External sources of finance

External finance refers to funds generated from outside of a business.
The main sources of external finance are:

Share capital: where funds are Loan capital: where funds are
invested on a permanent basis borrowed, to be repaid at some
into the business, in return for a point in the short, medium or
claim on any profits made. long term.

Share Capital
Owners of small businesses may use funds Venture capital providers invest
from personal sources, e.g. their own savings significant sums by buying shares
or those of friends and family. in small- or medium-sized
companies with potential for
rapid growth, but where the
Limited companies can increase the level of
degree of risk involved is high
ordinary share capital by selling additional
enough to deter other investors.
shares to new or existing shareholders.

However, raising finance by selling

Benefits & drawbacks shares dilutes the control of the
A key advantage of share capital is that the original owners.
capital invested does not have to be repaid
during the business’ lifetime. Venture capitalists usually demand a
substantial slice of a company’s shares
Shareholders are not automatically entitled and direct involvement in the way it is
to an annual dividend, for example, if the run, although they may also offer
company does not make a profit after tax or valuable business experience and
if directors decide to reinvest profits. expertise.

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Loan Capital
Most businesses obtain loan capital by Overdrafts are:
borrowing from banks, in the form of a bank - short term
loan or overdraft. - allow customers to withdraw
money up to an agreed limit
Bank loans are:
- usually fixed term, for one or more years,
- repaid in regular instalments or at the end
of the loan period

However, loan capital must be repaid

Benefits & drawbacks according to the terms agreed with the
A key advantage of using loan capital is that lender. Firms are often required to provide
it does not result in a dilution of ownership assets as security against a loan — these
or a loss of control. assets could be seized if the loan terms are
broken.
The size and term of both bank loans and Interest is also charged on loan capital,
overdrafts can be negotiated to suit the increasing costs and reducing profit levels.
needs of individual businesses. Interest charges on overdrafts are high if
they are not repaid quickly.

Sources of finance: factors to consider

• How much finance should be raised? The level should be sufficient to meet any likely
future, as well as current, needs.
• For how long will the finance be needed by the business? Using short-term sources to
finance long-term projects is likely to be expensive, putting pressure on cash flow.
• Are current owners prepared to give up some control over the business by bringing in
new investors?
• Are current owners prepared to take the risks involved with loan finance?

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Sources of Capital
The total capital of a business consists of equity or capital stock financing and
borrowed capital or debt financing or borrowings.

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.

Sources of Capital
Sole Proprietorship:
For single proprietorship, the amount provided by the
owner is the owner’s equity; Owner’s Equity:
for partnership, the partners’ equity; and Alpha, Capital January 1, 20BB Php 100,000
for corporation the stockholders’ equity. Add: Net Income, 20AA 50,000
Php 150,000
It may be presented as follows: Less: Drawings 20,000
Alpha, Capital December 20BB Php 130,000

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Sources of Capital

Corporation
Stockholder’s Equity:
Partnership Contributed Capital
12% Preferred, Non-participating
Authorized 40,000 shares, Par value Php 100.00
Issued 22,000 shares Php 2,200,000
Partner’s Equity: Contributed Capital
Alpha Php 150,000 Authorized 50,000 shares,
Beta 250,000 Par value Php 50.00
Charlie 100,000 Issued 40,000 shares 2,000,000
Total Partners’ Equity Php 500,000 Total Contributed Capital Php 4,200,000
Retained earnings
Appropriated for:
Plant expansion Php 1,000,000
Un-appropriated 3,000,000 4,000,000
Total Contributed Capital Php 8,200,000

01

Equity
Forms of Capital Stock

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EQUITY
Equity raised by issuing ordinary shares has important
advantages as a source of fund or capital.

Equity
First, a company is not required to pay dividends to ordinary shareholders – payment of dividends
is at the discretion of directors.
Second, ordinary shares do not have any maturity date which means that the issuing company has
no obligation to redeem them.
Third, the higher the proportion of equity in a company’s capital structure, the lower will be the
risk that creditors will suffer losses as a result of the borrower experiencing financial difficulty.
While equity has important advantages, it also has some disadvantages. One is that, 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 own ownership and control of the company. Borrowing, on the other hand, allows
funds to be raised without such dilution. Small shareholders may not be concern if their interest in a company
is diluted, provided that the new shareholders pay a fair price for the shares they obtain. Investors who own a
significant proportion of a company’s share may be unwilling to have their interest diluted.
Another factor that can be important is that dividends paid-out of after-tax profit are generally
subject to further taxation in the hands of investors. Interest on debt is tax deductible for the borrowing
company and taxable in the hands of creditors.
Capital stock financing supplies permanent funds to the business through equity or ownership
channels in the capital markets. It is concerned with demand and supply in the stock markets.

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Forms of Capital
Stock
Capital stock is the amount of common and preferred shares
that a company is authorized to issue—recorded on the balance
sheet under shareholders' equity.

Forms of Capital Stock

Authorized capital stock Issued stock
is the maximum number of shares that the is the amount of authorized
business owners are allowed to issue. This is stock subscribed to and paid for
determined by the articles of incorporation by in cash, property, or services. The
the stockholders. If a face and par value is number of shares issued at any
assigned to the shares, then the authorized one time may be equal to or less
amount is stated both in numbers and total than the authorized number of
values of shares. shares and never greater than
that number.

Reacquired stock Outstanding stock

These stocks can be reacquired in two ways: is the portion of issued stock not
One is by gift from stockholders; and the reacquired. The account indicates
other way is by buying back some of the the number of shares, the par value
company’s issued stock. By forfeiture, stocks if any for each share, and the sum of
can also be reacquired. This is, if purchaser the par value
fails to pay for it fully by the time stated in
the contract. Stocks that have been reacquired
after issue may be cancelled or held in the
treasury for resale at a later date.

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02

Classes of Stock
Common shares
Preferred shares

Classes of Stock
Financial managers should also understand the contractual provisions of
the stock forms for the following reasons:

Stock is authorized and Stock is reacquired by

Stock is voted on the
issued on the basis of the business in terms
basis of shares
shares. of shares

Assets are distributed

Profits are calculated Dividends are declared
in liquidation on the
on the basis of shares on the basis of shares
basis of shares

Stock purchase rights are

distributed on the basis
of outstanding shares

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Common Shares
Common shares are units of ownership registered in the names of the proprietors.
Rights and limitations are:

Right to share in profits

and dividends as residual
Right to vote or elect the board of
claimants after preferred
directors of a corporation at the
annual stockholders’ meeting. shares; and when the
management decides to
pay dividends.

Pre-emptive common law right on

issuance of common stock before
selling to public. Common Right to assets in liquidation,
stockholders are given stock where right is pro-rata based
purchase rights, by subscribing to during voluntary or forced
new shares before offering to liquidation.
public.

Preferred Shares
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.

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 are unpaid, dividends cannot be paid on common stocks.

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03

Financing
Debt financing – borrowings
External short-term financing: an assessment

Debt Financing – Borrowings

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

Debt due for repayment within a period of twelve months is classified as current or short-term. For
accounting entry purposes, debt with maturity term of more than twelve months is classified as non-current or
long-term. Where debt is secured, the creditor has claims against the borrower and against assets of the
borrower. If debt is unsecured, the lender has a claim against the borrower but no additional claim to any
particular property owned by the borrower.

Debt can also be classified into marketable and non-marketable debt. Marketable debt takes the
form of securities such as notes, bonds or debentures which are issued to investors and can be traded in a
secondary market – that is, 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.

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Debt Financing – Borrowings

The interest rate applicable to debt may be fixed or variable (floating). Most inter-company loans
and short-term bank loans involve a variable rate but borrowers can obtain short-term debt at a fixed rate by
issuing marketable securities such as bills. Similarly, most marketable long-term debt securities have a fixed
interest rate, which does not vary over the life of the security. Long-term loans can also have a fixed interest
rate. Where a variable interest rate applies, the rate will generally consist of a base rate plus a margin that
depends on the risk of the borrower. The interest rate will therefore change whenever the base rate or indicator
lending rate changes.

Capital from creditors gives rise to a liability, which can be in any of the following forms:
- Buying property, equipment, raw materials and availing of services on credit.
- Loans from financial intermediaries.
- Issuance of commercial papers and bonds.
- Advances from affiliate companies and officers.
- Accounts and notes receivables discounting.

Debt Financing – Borrowings

Financial leverage is the use of borrowed capital. The company organization is willing to pay interest and
other charges on borrowed capital with the intention of raising the earnings per share on common stock. Also, this
refers to the acquisition of additional funds, with costs involved. The financial advantage of increasing the capacity to
produce and sell, other sources of income, and business opportunities, and meet decline in economic cycle can be
attained in using borrowed capital.
Interest is the cost of borrowed capital. This is deductible for income tax purposes, and the tax benefit is
considered and adjustment to interest expense for determining the cost of borrowed capital. To illustrate:
Cost of borrowed capital = Interest x (1 – tax rate)

Supposing: Corporation Ruthy obtained a loan of Php 800,000, for a term of one-year from RN Financing Company at
20% interest. Rate of income tax is 35%.

Cost of borrowed capital = 20% x (1 – 35%) Interest of 20% on Php 800,000 Php 160,000
= .20 x (.65) Tax benefit @ 35% of Php 160,000 56,000
= .13 or 13% Interest expense net of tax benefit Php 104,000

Percentage (Php 104,000 / 800,000) 13%

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External Short-term Financing: An Assessment

External financing refers to a rather limited and specialized area in financial decision concerned
primarily with bringing new funds into the business. The size of the capital of a business acts as a kind of
material barriers to the amount of short-term financing that a business can do. A one-year period can be more
convenient to report financial conditions to stockholders and creditors.
The most important policy consideration to most businesses involved in short-term financing is
liquidity. In borrowing cash, this means getting all the funds that are needed to realize short-run operating
objectives, and in securing trade credit it means getting all the inventory that is needed to attain current
operating objectives. Liquidity of individual borrowing is measured by the percentage of cash secured on the
face value of the debt. Another primary risk of short-term financing is default on payment of principal and
interest, called solvency risk factor. Solvency risks increase as the total volume of short-term financing
increases. Third factor is profitability, measured in terms of opportunity cost, or what would be foregone for a
decision; and financial expenses such as service charges, interest charges and carrying charges. The profit
decision in short-term financing is different from the profit decision for inventory investment. The main
difference lies in knowing in advance what quantity of funds is needed for external financing. With the quantity
of financing known, the problem is choosing between alternative short-term fund sources. Assuming that the
competing supply sources offer the same amount of liquidity and solvency, financial management should choose
the source of funds with the minimum combined fixed and variable financial expenses.

02
Major Sources
of Funds
Equity vs. Debt financing: invested capital vs. borrowed capital
Loans and amortization

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Major Sources of Funds

Trade Credit Market Customer Loan Market Receivables Sales Market

The quantity of funds that can be obtained
is any place where cash funds can be
is limited by the quantity of credit sales
is any place where raw materials negotiated. Supply sources are commercial that are approved for purchase by the
or finished inventories may be banks, commercial paper companies or factoring company. Since this is not a
purchased on credit. Supply sources discount houses, non-banks discounting borrowing in the ordinary sense of the
may include manufacturers and unsecured promissory notes to mature in four world, no liability is created on the books
distributors from all over the to six months of date of issue; commercial of the business when receivables are sold to
country and other nations. finance companies – purchasing consumer a factor. Neither there is maturity,
Important supply factors to instalment paper. therefore, or a repayment date with which
consider are: In negotiating for loans, financial managers to be concerned. It may be looked at as
o total quantity of credit available are concerned primarily with the: control in its extreme form through
o inventory supply services o quantity of cash available ownership of receivables. Ownership is not
o cash and other related financial; services control at all, control exists at the point of
o financial expenses
o expenses for financing credit sales where the factor makes
o repayment terms decisions about which proposed receivables
o repayment terms;
o external controls are acceptable and which are not acceptable
o degree of control exercised over the
borrower for purchasing.

EQUITY VS.
DEBT FINANCING:
Invested Capital VS. Borrowed Capital

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EQUITY VS. DEBT FINANCING:

Invested Capital VS. Borrowed Capital

It is advisable, to a certain extent, to use borrowed capital if its rate of return is higher
than its cost. For example, Delta Corporation is intending to invest Php 1,000,000 for a project with an
expected rate of return at 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%

EQUITY VS. DEBT FINANCING:

Invested Capital VS. Borrowed Capital
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 less 10.4% cost of borrowed capital. The illustrations show that
utilizing borrowed capital will be advisable. Cash budgeting must provide for obligations to meet on loan
maturity for payment of principal and financing charges. This will not endanger the company’s financial
stability.

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LOANS and
AMORTIZATIONS
A loan is money, property, or other material goods given to another party in
exchange for future repayment of the loan value amount with interest.
Amortization refers to the process of paying off a debt through scheduled,
pre-determined installments that include principal and interest.

Loans and Amortizations

Whenever a creditor extends a loan, some provision will be made for repayment of the principal. A
loan might be repaid in equal installments, or it might be repaid in a single lump sum. The way principal and
interest shall be paid will depend on the agreement of both parties. Basic types of loans are: pure discount
loans, interest only loans, and amortized loans.
A pure discount loan is the simplest form of loan. The debtor received money today and repays a
single lump sum at some time in the future. A one-year, 10 percent discount loan, for example, would require
the debtor to repay Php 1.10 in one year for every peso borrowed today.

Suppose, a debtor was able to repay Php 25,000 in five years. On the part of the creditor who wants an interest
rate of 12 percent on the loan, how much would be the amount to lend now? Or what should be the amount of
loan today, to get Php 25,000 on the fifth year?
This can be a discussion of time value of money, but for this purpose, below is the illustration:
Present value = Php 25,000 / 1.7623 (refer to Table on Future Value at the end of the t periods)
= Php 14,186
Treasury bills are pure discount loans. If a T-bill promises to repay Php 10,000 in 12 months, and the market
interest is 7 percent, how much will the bill sell for in the market?
Present value = Php 10,000 / 1.07
= Php 9,345.79

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Loans and Amortizations

Interest-only loans allow the debtor to pay interest each period and to repay the principal at some
point in time. Notice that if there is just one period, a pure discount loan and interest-only loan are the same.
For example, with a three-year, 10 percent, interest-only loan of Php 10,000, the debtor would pay
Php 10,000 x .10 = Php 1,000 in interest at the end of the first and second years. At the end of the third year,
the borrower would return the Php 10,000 along with another Php 1,000 in interest for that year. Most corporate
bonds have the general form of interest-only loan, which will be discussed at the latter part of the book.

Amortized loan requires the debtor to repay parts of the loan amount over time. The debtor pays the
interest each period plus fixed amount. The process provides loan payments on regular principal reductions.
Suppose, a business takes out a Php 50,000, five-year loan at 9 percent. The loan agreement calls
for the debtor to pay the interest on the loan balance each year and to reduce the loan balance each year by
Php 10,000. Because the loan amount declines by Php 10,000 each year, it is fully paid in five years.

Loans and Amortizations

Notice that in each year, the interest paid is given by the beginning balance multiplied by the interest rate.
Also notice that the beginning balance is given by the ending balance from the previous year.

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Loans and Amortizations

The most common way of amortizing a loan is to have the borrower make a single, fixed payment every period.
Almost all consumer loans, like car loans and mortgages work this way. For example, suppose our five-year, 9 percent Php
50,000 loan was amortized this way, the illustration is as follows:
Amortization = Php 50,000 / 3.8897 (refer to Table on Present Value of Annuity for t periods)
= Php 12,854.46

Debtor will therefore make five equal payments of Php 12,854.46. In the first year, the interest is
Php 4,500, therefore total principal payment is Php 8,354.46. (Php 12,854.46 – 4,500).

Loans and Amortizations

Because the loan balance declines to zero, the five equal payments do pay off the loan. Notice that
the interest paid declines each period. This is because the loan balance is going down. Given that the total
payment is fixed, the principal paid must be rising each period. If the two loan amortizations will be compared,
total interest is greater for the equal total payment case, Php 14,273.29 versus Php 13,500. This is for the reason
that loan is repaid more slowly early on, so the interest is somewhat higher. This does not mean that one loan is
better than the other; but the other one is effectively paid off faster than the other. Wherein, the principal
reduction in the first year is Php 8,354.46 compared to Php 10,000 in the first case.

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Reminder: Messaging Rules

Messages in CLASSIN will ONLY be entertained and it should
always contain the following:

- NAME
- CLASS SCHEDULE
- COURTEOUS GREETING
- CONCERN/QUERY (WHAT DO YOU WANT ME TO DO)

SAMPLE MESSAGE:
Juan Dela Cruz
AOM1 Monday 8:00 – 9:30 AM
Good morning Ma’am Gennelyn.
I have taken my Final quiz 1 but I did not receive my score.
Kindly check your class record. Thank you Ma’am.

Do you have any questions?

Thank you
for listening!

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