Business Finance

Sources of finance, cost of capital, capital structure

Sources of finance are classified by period, ownership and source. Short-term sources include trade credit, bank overdrafts, commercial paper, factoring and short-term loans. Medium-term sources include term loans, debentures and lease finance. Long-term sources include equity shares, preference shares, debentures, retained earnings and term loans. Ownership classification separates owned capital, equity and retained earnings, from borrowed capital, debentures and loans. Internal sources, retained earnings and depreciation provisions, need no fresh issue and carry no repayment obligation, while external sources require issue costs, disclosure and sometimes security. The right mix depends on cost, risk, control, flexibility, maturity matching, and the firm's stage: a young firm leans on equity and internal funds, a mature firm with stable cash flow can support more debt.

Cost of capital is the minimum return a firm must earn on investment to satisfy its fund providers. Cost of debt is interest adjusted for tax, because interest is deductible, so after-tax cost equals interest rate multiplied by one minus the tax rate, adjusted for issue price where debt is issued at premium or discount. Cost of preference shares is dividend divided by net proceeds. Cost of equity is harder because equity has no fixed return; the dividend growth model divides next dividend by current price and adds growth, while the capital asset pricing model adds a risk premium, beta multiplied by market premium, to the risk-free rate. Cost of retained earnings equals cost of equity, since shareholders forgo dividends to fund the firm, with an adjustment for personal tax and brokerage where relevant. Weighted average cost of capital weights each source by its proportion in the capital structure, using market values where available, because book weights may misstate current opportunity cost.

Capital structure theories debate whether the mix affects value. The net income approach argues that cheaper debt lowers overall cost as leverage rises, raising value. The net operating income approach argues that rising equity risk exactly offsets cheaper debt, so overall cost and value are unchanged. The traditional approach argues for an optimum: overall cost falls at first as cheap debt dominates, then rises as financial risk grows, giving a U-shaped cost curve and a value-maximising debt level. The Modigliani and Miller proposition, without taxes, states that value is independent of leverage because investors can replicate leverage themselves; with taxes, debt adds value through the tax shield, implying high debt, a result later softened by bankruptcy costs, agency costs and pecking order behaviour. The pecking order theory argues firms prefer internal funds first, then debt, then equity, because equity issue signals overvaluation. The practical conclusion is a target range rather than a precise point: borrow enough to gain the tax shield and discipline, but not so much that distress risk, loss of flexibility and rising borrowing costs dominate.

Capital budgeting, working capital and dividend decisions

Capital budgeting evaluates long-term investment. The payback period measures how quickly cumulative cash inflows recover the initial outlay, and is simple but ignores cash flows after payback and the time value of money. Discounted payback corrects the second flaw but not the first. Net present value discounts all cash inflows and outflows at the cost of capital and subtracts initial investment: a positive value adds to shareholder wealth and the project should be accepted. Internal rate of return is the discount rate that makes net present value zero: accept if it exceeds the cost of capital. Profitability index divides present value of inflows by initial investment, and is useful for ranking under capital rationing. Where net present value and internal rate of return conflict, for mutually exclusive projects with different scales or timing, net present value is generally preferred because it measures absolute wealth added and assumes reinvestment at the cost of capital, while internal rate of return assumes reinvestment at its own rate and can give multiple values when cash flows change sign more than once.

Working capital is the difference between current assets and current liabilities, and its management is the management of the operating cycle: the time from paying for raw materials to collecting cash from customers. The cycle length equals inventory days plus receivables days minus payables days. A long cycle locks cash in stock and debtors and needs more financing; a short cycle releases cash. Cash management seeks the balance between holding too much idle cash and running out, using cash budgets, Baumol's model for regular cash needs, and Miller and Orr's model where cash flows are unpredictable and control limits trigger transfers. Receivables management sets credit standards, credit period, cash discount and collection policy, trading higher sales against bad debts and financing cost. Inventory management balances ordering cost against carrying cost, with economic order quantity giving the order size that minimises their sum, and techniques such as just-in-time, ABC classification and safety stock controlling different items differently. Overtrading, growing sales faster than working capital can support, is a classic cause of failure in otherwise profitable firms.

Dividend policy decides how much profit to distribute and how much to retain for growth. The Walter model links dividend choice to the relation between return on investment and cost of capital: if return exceeds cost, retention creates value and a low payout is optimal; if return is below cost, distribution is better. The Gordon model similarly values shares through future dividends growing at a rate funded by retention. Modigliani and Miller's dividend irrelevance proposition argues that, under perfect markets with no taxes or transaction costs, dividend policy does not affect value, because investors can create their own dividends by selling shares. In practice, taxes, signalling, agency costs, clientele preferences and the need for stable dividends make policy relevant: a cut may signal trouble, a stable or rising dividend signals confidence, and different investors prefer income or growth. Forms of distribution include cash dividends, bonus shares, share splits, which change the number of shares without changing total capital, and buy-backs, which return cash and reduce shares outstanding.

International finance

International finance studies money flows across borders. The exchange rate is the price of one currency in terms of another, quoted directly or indirectly, with spot rates for immediate delivery and forward rates for future delivery. A forward premium or discount reflects interest rate differentials under covered interest parity: the currency of the higher-interest country tends to trade at a forward discount. Purchasing power parity argues that exchange rates move to equalise price levels, so a country with higher inflation tends to see its currency depreciate. Interest rate parity links interest differentials to forward rates, while the international Fisher effect links interest differentials to expected inflation differentials. These parities are benchmarks, not exact predictions, and deviations create opportunities and risks.

Firms face three kinds of exchange exposure. Transaction exposure arises from contracted foreign currency receivables and payables whose home currency value changes before settlement. Translation exposure arises when foreign subsidiaries' statements are converted into the parent currency. Economic exposure arises from the effect of exchange changes on future competitiveness, demand and costs, even without contracted flows. Hedging tools include forward contracts that lock a rate, futures and options that give flexibility at a price, money market hedges that borrow or lend to offset a flow, netting and leading or lagging within a group, and invoicing in the home currency where bargaining power allows. Each tool trades certainty against cost and flexibility, and hedging a translation exposure that has no cash flow effect may be wasteful.

International financing instruments include Eurocurrency loans, foreign bonds issued in another country's market in its currency, Eurobonds issued in a currency other than that of the market of issue, global depository receipts and American depository receipts that let foreign shares trade domestically, and external commercial borrowings. Institutions such as the International Monetary Fund provide balance of payments support and stability, the World Bank group finances development, and regional development banks finance regional projects. For a firm, the international decision is never only about the cheapest interest rate: currency risk, political risk, convertibility, withholding tax, legal enforcement and the maturity of the local capital market must be weighed alongside the headline rate.

Capital budgeting methods compared

Dividend theories at a glance