Sources of Business FinanceClass 11 Business Studies NCERT Solutions
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Q1Long Answer Questions
Explain trade credit and bank credit as sources of short-term finance for business enterprises.
Solution
Trade credit and bank credit are two important sources of short-term finance for business enterprises.
Trade Credit
Trade credit is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment. It is a convenient and continuous source of funds for a business.
- Merits:
- It is readily available to customers with good financial standing.
- It helps promote the sales of an organisation.
- It allows a firm to increase its inventory to meet expected demand without immediate cash outflow.
- It does not create any charge on the assets of the firm.
- Limitations:
- Easy availability may induce a firm to indulge in overtrading, which increases risk.
- Only a limited amount of funds can be generated through it.
- It can be a costly source of funds if discounts for prompt payment are foregone.
Bank Credit
Commercial banks are a vital source of finance for different time periods. For short-term needs, they extend loans in many ways, such as cash credits, overdrafts, and discounting of bills. Bank credit is not a permanent source of funds and is usually granted against some security or charge on the assets of the firm.
- Merits:
- Banks can provide timely funds as and when needed by the business.
- Information provided to the bank is kept confidential, thus maintaining business secrecy.
- It is an easier source of funds as it does not require formalities like issuing a prospectus.
- It is a flexible source, as the loan amount can be increased or repaid in advance as per business needs.
- Limitations:
- Funds are generally available for short periods, and renewal can be uncertain.
- The process can be difficult as banks conduct a detailed investigation and may require security and personal sureties.
- Banks may impose difficult terms and conditions, such as restrictions on the sale of mortgaged goods.
Q2Long Answer Questions
Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.
Solution
A large industrial enterprise requires significant long-term capital for financing modernisation and expansion. The following sources are suitable for this purpose:
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Issue of Equity Shares: This is the most important source of raising long-term capital. It represents ownership capital and is permanent, as it is repaid only at the time of liquidation. It provides creditworthiness to the company and does not create any charge on assets, leaving them free to be mortgaged for further borrowings.
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Issue of Debentures: Debentures are an important instrument for raising long-term debt capital. They carry a fixed rate of interest, and the interest paid is a tax-deductible expense, which makes it a less costly source of finance. This is suitable when the company's sales and earnings are relatively stable.
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Loans from Financial Institutions: The government has established several financial institutions (also called 'development banks') to provide long-term finance for industrial development. These institutions are suitable when large funds are required for expansion, reorganisation, and modernisation. Besides funds, they also provide technical and managerial advice.
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Retained Earnings: This refers to the ploughing back of profits. A large, established enterprise can use its accumulated profits for financing its modernisation and expansion needs. It is a source of internal financing that does not involve any explicit cost like interest or dividend and allows for greater operational freedom.
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International Financing: A large enterprise can also tap international capital markets. This can be done through:
- Global Depository Receipts (GDRs) and American Depository Receipts (ADRs): These instruments allow an Indian company to raise funds in foreign currency by issuing shares on foreign stock exchanges.
- Foreign Currency Convertible Bonds (FCCBs): These are debt securities issued in a foreign currency that can be converted into equity shares after a specific period.
- Loans from International Banks and Agencies: Funds can also be raised through foreign currency loans from international commercial banks and development agencies.
Q3Long Answer Questions
What advantages does issue of debentures provide over the issue of equity shares?
Solution
From the perspective of a company, issuing debentures offers several advantages over the issue of equity shares:
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No Dilution of Control: Debenture holders are creditors, not owners, and they do not have voting rights. Therefore, financing through debentures does not dilute the control of existing equity shareholders over the management of the company. In contrast, issuing new equity shares extends voting rights to new shareholders, diluting the control of existing ones.
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Lower Cost: Financing through debentures is generally less costly than equity capital. The interest paid on debentures is a tax-deductible expense, which reduces the effective cost to the company. Dividends paid to equity shareholders are not tax-deductible.
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Fixed Financial Burden: Debentures carry a fixed rate of interest. This means that in times of high profitability, the company pays only the fixed interest, and the entire surplus profit is available for equity shareholders. The return for equity shareholders is not fixed and can grow with the company's earnings.
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Trading on Equity: When the rate of return on the company's investment is higher than the rate of interest on debentures, the company can declare higher rates of dividend for its equity shareholders. This is known as trading on equity.
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Attraction for Cautious Investors: Debentures appeal to investors who want a fixed income at a lesser risk. This allows the company to tap into a different segment of investors who may not prefer the risk associated with equity shares.
Q4Long Answer Questions
State the merits and demerits of public deposits and retained earnings as methods of business finance.
Solution
Public Deposits
Public deposits are the deposits raised by organisations directly from the public. They can meet both medium and short-term financial requirements.
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Merits:
- Simple Procedure: The procedure for obtaining deposits is simpler and involves fewer restrictive conditions compared to a loan agreement with a bank or financial institution.
- Lower Cost: The cost of public deposits is generally lower than the cost of borrowings from banks and financial institutions.
- No Charge on Assets: Public deposits usually do not create any charge on the company's assets. This keeps the assets free to be used as security for raising loans from other sources.
- No Dilution of Control: Depositors do not have voting rights, so the control of the company's management is not diluted.
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Demerits:
- Difficult for New Companies: New companies generally find it difficult to raise funds through public deposits as they lack a track record to win public confidence.
- Unreliable Source: It is an unreliable source of finance because the public may not respond, especially when the company needs money during a downturn.
- Difficult to Collect Large Amounts: Collection of funds can be difficult, particularly when the size of deposits required is large.
Retained Earnings
This is the portion of net earnings that is retained in the business for future use, also known as ploughing back of profits.
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Merits:
- Permanent Source: Retained earnings are a permanent source of funds available to the organisation.
- No Explicit Cost: It does not involve any explicit cost in the form of interest, dividend, or floatation cost.
- Operational Freedom: As the funds are generated internally, there is a greater degree of operational freedom and flexibility.
- Absorbs Losses: It enhances the capacity of the business to absorb unexpected losses.
- Increases Share Value: It may lead to an increase in the market price of the company's equity shares.
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Demerits:
- Shareholder Dissatisfaction: Excessive ploughing back may cause dissatisfaction amongst shareholders, as they would receive lower dividends.
- Uncertain Source: It is an uncertain source of funds as the profits of a business fluctuate.
- Sub-optimal Use: The opportunity cost associated with these funds is often not recognised, which may lead to their sub-optimal use.
Q1Projects/Assignment
Collect information about the companies that have issued debentures in recent years. Give suggestions to make debentures more popular.
Solution
This is a project-based activity that requires external research. Based on the chapter, here is a framework for approaching this task.
Part 1: Collecting Information
Students should research financial news websites and company reports to find Indian companies that have recently issued debentures. The information to collect for each company could include:
- Name of the Company
- Type of Debenture Issued (e.g., Convertible/Non-Convertible, Secured/Unsecured)
- Total Amount Raised
- Interest Rate (Coupon Rate)
- Maturity Period
- Credit Rating (e.g., from CRISIL)
Part 2: Suggestions to Make Debentures More Popular
Based on the merits and limitations discussed in the chapter, the following suggestions can be made to make debentures more popular among investors and companies:
- For Investors:
- Enhance Security: Promote the issuance of secured debentures, which create a charge on company assets, providing greater safety to investors.
- Introduce Innovative Features: Offer debentures with features like conversion into equity shares (convertible debentures) or floating interest rates to attract investors willing to take slightly more risk for higher returns.
- Improve Credit Rating Awareness: Educate investors about the importance of credit ratings so they can make informed decisions based on the company's financial health.
- For Companies:
- Simplify Issuance Process: Streamline the legal and procedural formalities to make the issuance process faster and less cumbersome.
- Target Specific Investor Groups: Design debenture issues to appeal to specific groups, such as risk-averse investors who prefer a fixed and steady income.
Q2Projects/Assignment
Institutional financing has gained importance in recent years. In a scrapbook paste detailed information about various financial institutions that provide financial assistance to Indian companies.
Solution
This is a scrapbook project requiring external research. The chapter provides a basis for understanding what to look for.
Students should create a scrapbook focusing on financial institutions. The chapter categorises these into:
- Development Banks: These are established by central and state governments to promote industrial development. An example mentioned is ICICI.
- Commercial Banks: These provide short and medium-term loans. Examples mentioned include State Bank of India, Canara Bank, and Punjab National Bank.
- International Agencies and Development Banks: Examples include the International Finance Corporation (IFC), EXIM Bank, and Asian Development Bank (ADB).
For each institution, the scrapbook could include the following information, gathered from their official websites and financial publications:
- Name and Logo of the institution.
- Year of Establishment and a brief history.
- Objectives: The primary purpose for which it was set up (e.g., financing small industries, promoting exports, funding infrastructure).
- Types of Financial Assistance Provided: Details on the kinds of loans, capital, and other services they offer (e.g., long-term loans, owned capital, technical assistance, market surveys).
- Eligibility Criteria: The types of businesses or projects they typically fund.
- Notable Projects Funded: Examples of well-known companies or projects that have received financial assistance from them.
Q3Projects/Assignment
On the basis of the sources discussed in the chapter, suggest suitable options to solve the financial problem of the restaurant owner.
Solution
The restaurant owner, Mr. Anil Singh, needs funds for expansion. His personal sources are insufficient. Based on the chapter, here are suitable options and their analysis:
Mr. Singh's business is currently a small enterprise, likely a sole proprietorship. His options depend on the form of organisation he is willing to adopt and the level of control he wishes to retain.
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Partnership:
- Suggestion: As his father suggested, he can enter into a partnership with another person who brings in more funds.
- Analysis: This would increase the available capital. However, it would require sharing profits and, crucially, sharing control of the business, which Mr. Singh may not want.
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Bank Loan (from a Commercial Bank):
- Suggestion: He can apply for a medium or long-term loan from a commercial bank.
- Analysis:
- Merits: He would retain full control of his business and all profits. Bank loans are a flexible source of finance.
- Limitations: The loan will have to be repaid with interest, creating a fixed financial burden. The bank will conduct a detailed investigation and will likely require security (charge on assets). This might be difficult if the business does not have significant fixed assets to mortgage.
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Forming a Company (to Issue Shares and Debentures):
- Suggestion: This is a long-term option suggested by his friend Ramesh. Mr. Singh could convert his business into a private limited company.
- Analysis:
- Issue of Equity Shares: He could issue shares to a limited number of people (friends, family) to raise capital. This would bring in owner's funds without the burden of interest payments. However, like a partnership, it would mean diluting ownership and sharing control with the new shareholders.
- Issue of Debentures: This is generally not a viable option for a small, new company as it requires a strong credit rating and stable earnings to attract investors.
Recommendation:
For a business of this size and stage, a bank loan appears to be the most suitable initial option. It allows Mr. Singh to retain full control and ownership, which is important for an entrepreneur motivated by his initial success. While it creates a repayment obligation, the profits from the expanded chain of restaurants can be used to service the debt. If a bank loan is not sufficient or available, forming a private limited company with a trusted circle of investors would be the next best step for raising substantial capital for a large-scale expansion.
Q4Projects/Assignment
Prepare a comparative chart of all the sources of finance.
Solution
Here is a comparative chart of major sources of finance discussed in the chapter:
| Source of Finance | Type of Capital | Time Period | Cost | Control Dilution | Security Required | Suitable For |
|---|---|---|---|---|---|---|
| Retained Earnings | Owner's Funds | Long-term | No explicit cost (has opportunity cost) | No | No | Internal financing for growth and expansion |
| Equity Shares | Owner's Funds | Permanent | High (dividends, floatation costs) | Yes | No | Long-term capital, creating a company |
| Preference Shares | Owner's Funds | Long-term | Fixed dividend (higher than debenture interest) | No (no voting rights) | No | Investors seeking fixed income with low risk |
| Debentures | Borrowed Funds | Long-term | Fixed interest (tax-deductible, lower cost) | No | Yes (charge on assets) | Stable companies needing long-term debt |
| Loans from Banks | Borrowed Funds | Short/Medium-term | Interest payments | No | Yes | Meeting working capital and medium-term needs |
| Financial Inst. | Borrowed Funds | Long-term | Interest payments (may have restrictions) | Sometimes (nominee director) | Yes | Large funds for modernisation and expansion |
| Public Deposits | Borrowed Funds | Short/Medium-term | Interest (lower than bank loans) | No | No | Reputed companies for medium-term needs |
| Trade Credit | Borrowed Funds | Short-term | Implicit cost (loss of cash discount) | No | No | Financing purchase of supplies and inventory |
| Commercial Paper | Borrowed Funds | Short-term | Discount rate (lower than bank loans) | No | No | Highly-rated corporations for short-term funding |
| Lease Financing | Borrowed Funds | Medium-term | Lease rentals | No | No (asset is not owned) | Acquiring assets (e.g., equipment) without purchase |
| Factoring | Borrowed Funds | Short-term | Discount and fees (can be expensive) | No | No (receivables are sold) | Managing receivables and improving cash flow |
Q1Short Answer Questions
What is business finance? Why do businesses need funds? Explain.
Solution
Business finance refers to the money required by a business to carry out its various activities. It is considered the lifeblood of any business because no business can function without adequate funds.
Businesses need funds for the following reasons:
- Fixed Capital Requirements: To start a business, funds are needed to purchase fixed assets like land, buildings, plant, machinery, and furniture. This is known as the fixed capital requirement. These funds remain invested in the business for a long period.
- Working Capital Requirements: A business needs funds for its day-to-day operations. This is known as working capital, which is used for holding current assets like stock of raw materials, paying salaries, wages, taxes, and rent. The amount needed depends on factors like sales turnover and whether the business sells on credit.
- Growth and Expansion: When a business grows and expands, it needs additional funds. Funds may be required for upgrading technology, building higher inventories for a festive season, or shifting to a new location. A clear assessment of these financial needs is a significant aspect of running a business.
Q2Short Answer Questions
List sources of raising long-term and short-term finance.
Solution
Based on the time period, the sources of business finance can be classified as long-term and short-term.
Sources of Long-term Finance (for a period exceeding 5 years):
- Issue of Equity Shares
- Issue of Preference Shares
- Issue of Debentures
- Retained Earnings
- Long-term borrowings and loans from Financial Institutions
- International sources like GDRs, ADRs, and FCCBs
Sources of Short-term Finance (for a period not exceeding 1 year):
- Trade Credit
- Loans from Commercial Banks (e.g., cash credit, overdraft)
- Commercial Papers
- Factoring
- Public Deposits (can also be for medium-term)
Q3Short Answer Questions
What is the difference between internal and external sources of raising funds? Explain.
Solution
The difference between internal and external sources of raising funds is based on whether the funds are generated from within the business or from outside sources.
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Internal Sources of Funds: These are the funds that are generated from within the business. Examples include accelerating the collection of receivables, disposing of surplus inventories, and ploughing back profits (retained earnings). Internal sources can fulfill only the limited needs of a business and are generally used for expansion and growth without involving outside parties.
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External Sources of Funds: These include all sources that lie outside an organisation. Examples include funds from suppliers (trade credit), lenders (banks, financial institutions), and investors (shareholders, debenture holders). When a large amount of money is required, it is generally raised through external sources. These sources may be costlier and often require the business to mortgage its assets as security.
Q4Short Answer Questions
What preferential rights are enjoyed by preference shareholders. Explain.
Solution
Preference shareholders enjoy a preferential position over equity shareholders in two specific ways:
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Preferential Right to Dividend: They have the right to receive a dividend at a fixed rate out of the net profits of the company before any dividend is declared for the equity shareholders. This ensures a more stable and predictable income for them compared to equity shareholders.
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Preferential Right to Repayment of Capital: In the event of the company's liquidation (winding up), preference shareholders have the right to receive their capital back after the claims of the company's creditors have been settled, but before any capital is repaid to the equity shareholders. This makes their investment safer compared to equity shares.
Q5Short Answer Questions
Name any three special financial institutions and state their objectives.
Solution
The chapter discusses various international agencies and development banks that function as special financial institutions to finance trade and business. Three such institutions mentioned in the text are:
- International Finance Corporation (IFC)
- EXIM Bank (Export-Import Bank)
- Asian Development Bank (ADB)
The common objective of these institutions, along with domestic development banks like ICICI, is to promote industrial development. They achieve this by:
- Providing long and medium-term loans and grants, especially for projects in economically backward areas.
- Supplementing traditional financial agencies like commercial banks by providing funds for expansion, reorganisation, and modernisation.
- Conducting market surveys and providing technical assistance and managerial services to the enterprises they fund.
Q6Short Answer Questions
What is the difference between GDR and ADR? Explain.
Solution
Both Global Depository Receipts (GDRs) and American Depository Receipts (ADRs) are financial instruments used by companies to raise funds from international capital markets. However, there is a key difference between them:
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Global Depository Receipts (GDR): A GDR is a depository receipt denominated in US dollars, issued by a depository bank against the underlying shares of a company. It can be listed and traded freely on any stock exchange outside the United States.
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American Depository Receipts (ADR): An ADR is a depository receipt issued by a company specifically for raising funds in the USA. The primary difference is that ADRs can be issued only to American citizens and can be listed and traded only on a stock exchange in the USA.
In essence, an ADR is a specific type of GDR that is restricted to the US market, while a GDR can be traded in global markets excluding the US.