Q. 1. Discuss the factors affecting the choice of source of funds.
Ans. Following are the factors affecting the choice of source of funds:
(i) Cost: It refers to the cost incurred in obtaining the funds and the cost of using the funds. So, while deciding about the source of funds both the costs should be taken into consideration.
(ii) Flexibility and ease: Borrowings from banks and financial institutions involve many restrictions, detailed investigation and documentation is needed. Therefore, the business firms may not prefer them in case other sources are easily available.
(iii) Effect on credit worthiness: The creditworthiness of business is affected by the use of certain sources. For example, the issue of secured debentures by a company may lead to withdrawal of loans by unsecured creditors. It might become difficult for the company to raise further unsecured loans.
(iv) Form of organisation and legal status: The form of legal status of business firms also affects the choice of the source of finance. For example, a sole proprietorship or a partnership firm cannot obtain funds by issue of equity shares as these can be issued only by joint stock companies.
(v) Purpose and time period: The time period for which the funds are required also affects the selection of the source of funds. For example, if the funds are required for short period, sources such as trade credit, commercial papers, etc. can be used. For long term, sources such as issue of shares, debentures, etc. are preferred. Therefore, purpose of the business should also be considered while choosing the source of finance.
(vi) Tax benefits: Certain sources of funds like debentures and loans provide tax benefits. The interest payable on them is tax deductible. Hence, the organisations seeking tax advantage prefer to raise funds through debentures or loans.
Q. 2. Explain the nature and significance of business finance.
Ans. Finance is the life blood of any business. It refers to the funds required by the business for carrying out various business activities. Availability of adequate funds is essential for the smooth functioning of a business. The capital contributed by the promoters may not be sufficient. Hence, the business firms have to look for other sources from where the fund requirements can be met. The financial requirements of a business can be categorised as follows:
(i) Fixed capital requirements: The funds that are invested in the business for a longer period of time are known as fixed capital. Such funds are usually required for starting the business and to purchase fixed assets like land, building, plant and machinery. Different business firms require different amount of fixed capital depending on various factors such as nature and size of the business, number of products produced, etc.
(ii) Working capital requirements: The funds required for day-to-day operations of the business are known as working capital. Different business firms require different amounts of working capital depending upon various factors. For example, a business firm selling goods on credit or having a slow sales turnover requires more working capital as compared to a business firm selling goods on a cash basis or having a high sales turnover.
Q. 3. Explain the merits and demerits of retained earnings.
Explain any five merits of ‘retained earnings’ as a source of finance.
‘As a source of finance, retained earnings are better than other sources’. Write five reasons to support this statement.
Ans. Merits: The merits of retained earnings as a source of finance are as follows:
(i) Retained earnings are a permanent source of funds available to an organisation.
(ii) It does not involve any explicit cost in the form of interest, dividend or flotation cost.
(iii) As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
(iv) It enhances the capacity of the business to absorb unexpected losses.
(v) It may lead to increase in the market price of the equity shares of a company.
Demerits: The demerits of retained earnings are as follows:
(i) There is imbalanced growth as undistributed profits remain in the same industry.
(ii) Since the profits of business fluctuate from time to time, it is an uncertain source of funds.
(iii) Excessive retained earnings causes dissatisfaction amongst the shareholders as this reduces the amount of the dividend receivable by them.
(iv) Frequent capitalisation of reserves may result in over capitalisation.
(v) Many firms fail to recognise the opportunity cost associated with these funds. This results in sub- optimal use of the funds.
Q. 4. Briefly explain any five merits of issuing equity shares.
Write a short note on equity shares and also mention its merits.
Ans. The capital obtained by the issue of equity shares is known as equity share capital. It is an important source of obtaining long-term finance. Equity shareholders are the owners of the company. The rate of dividend is paid after meeting all other claims. These shareholders have a right to vote and participate in the management of the company. They enjoy the reward as well as bear the risk.
(i) Equity share capital does not create any charge on the assets of the company.
(ii) Voting rights of equity shareholders assure democratic control over the management of the company.
(iii) Equity share capital is to be repaid only at the time of winding up of a company and hence it is permanent capital of the business.
(iv) There is no burden on the company in respect of dividend payable to equity shareholders because it is not compulsory to pay dividend.
(v) Equity shares are generally suitable for those investors who are willing to undertake risk for higher returns.
(vi) Equity share capital increases the credit- worthiness of the company and also provides confidence to prospective loan providers.
Q. 5. State the limitations of preference shares.
Ans. The limitations of preference shares are as follows:
(i) Rate of dividend payable on preference shares is higher than the rate of interest on debentures.
(ii) The claim of equity shareholders over assets of the company is affected by the issue of preference share capital.
(iii) Investors willing to take risk and earn higher returns do not prefer preference shares.
(iv) Since dividend paid is not deductible from profits as expense, there is no tax saving as in case of interest on debentures or loans.
(v) There is no consistent return for the investors because the dividend is payable to the preference shareholders only when the company earns profit.