SENIOR HIGH SCHOOL

First Semester S.Y. 2020-2021

MODULE 8
BUSINESS FINANCE

Name: _______________________________ Date :__________

Grade/Section: ________________________ Week : 8
Track/Strand: _________________________
SOURCES AND USES OF SHORT-TERM AND
LONG-TERM FUNDS
WHAT IS THIS ALL ABOUT?

The total financing requirement of a business may be financed by term and long-term
funds depending on how conservative or aggressive management is. It is therefore imperative
for a businessman to have adequate knowledge of the different sources of financing and the
costs involved.

WHA T DO YOU EXPECT TO LEARN?

Content Standard:
The learners demonstrate understanding of the:
1. sources and uses of short-term and long-term funds, and the
requirements, procedure, obligation to creditor, and reportorial
necessities.

Performance Standard:
The learners should be able to:
1. identify the bank and non-bank institutions in the vicinity that are
possible sources of funds, and enumerate their requirements and
process for loan application.

Objectives:
After the lesson, the learners should be able to:
1. identify uses of funds;
2. distinguish long-term from short-end interest;
3. list down obligations of entrepreneurs to creditors; and
4. solve the given problems from the topic discussed.

PRELIMINARY ACTIVITY

Managing Credit

At one time or another almost everyone borrows money. You might need
to borrow to buy a car, pay for your education, or purchase a place to live.
There are very few people who can buy these goods or services without the use
of borrowed funds. To borrow funds, however, you need to convince lending
institutions that you are a good credit risk. The best way to accomplish this is to
build a good credit history or personal financial record that shows you use
money responsibly and pay your debts on time.

Directions: Explain why each of the following individuals is making a

mistake that will harm his or her credit histories in ways that may prevent the
person from obtaining credit when it is needed in the future.

1. Cecil rents an apartment for P600 each month. She often fails to make her
rent payments on time. Last year she skipped her rent for more than two
months and paid only when her landlord threatened to have her evicted.
This could harm Cecil’s credit history because
2. Jayson never holds a job for more than a few months at a time. He always
finds a reason to quit or is fired because he doesn’t come to work on time.
Last year he held six different jobs.
This could harm Jayson’s credit history because

3. Libeth has a number of credit cards that she uses to buy clothing and other
products. She often forgets to make her payments on time and is forced to
pay late fees. She has also run up charges that exceed her credit card limits
from time to time.
This could harm Libeth’s credit history because

SOURCES OF LONG-TERM FUNDS

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The sources of long-term funds are reflected in the items appearing on the right side of the
balance sheet under the classifications - long-term liabilities and Stockholders equity. Thus,
they are the following:
 Long-term mortgage of plant and other real estate items owned by the company.
 Long-term chattel mortgage of property' and equipment and other movable assets
owned by the business.
 Issuance of long-term commercial papers.
 Issuance of corporate bonds.
 Issuance of shares of capital stock, common and preferred.

Long-term debt is known as debt capital and stock holders' equity, as equity capital. The
mix of debt capital and equity capital is called the capital structure.

In obtaining long-term loans, the lender usually lends up to 80% of the fair market value of
the property offered as collateral by the borrower and the standard requirements are:

a. torrens title for real estate;

b. purchase invoice/certificate of ownership for able property;
c. tax declaration for real property;
d. insurance coverage for buildings and movable property; and
e. audited financial statements.

The interest rate may be fixed or subject to changes based on fluctuations in prevailing
interest rates.

Corporate Bonds. These are certificates of indebtedness with par (face) value and clearly
defined terms. The terms include maturity date, interest payment dates and possible
convertibility to common stock.
 Corporate Stock. This term refers to ownership in a corporation. It is divided into shares
and ownership of these shares is evidenced by stock certificates.

CREDIT RATING

A credit rating is an opinion on the financial soundness of an enterprise and its

capability to repay its debts and the corresponding interest. It is a tool for risk assessment and
as such, it provides investors with a simple and objective indicator of default risk to
supplement their own credit evaluation.

Analytical Process in Credit Evaluation. Credit ratings are arrived at based on an

analytical process that considers quantitative and qualitative factors. Quantitative analysis
focuses on cash flows, profitability, liquidity, financial flexibility, capital adequacy, asset
quality and asset/liability management.

Importance of Credit Ratings in the Capital Market. A credit rating benefits the
three parties to debt security issues. For buyers of debt securities (investors/creditors), the
benefits are as follows:
 Reduced uncertainty. This encourages capital market growth and improves market
efficiency and liquidity.
 Wider investment horizons. This helps investors analyze potential debt investments
across different industries and countries.

CREDIT RATINGS IN THE PHILIPPINES

It may be noted that the ratings for corporate issuers range from "PRS Aaa — Very
Strong, to "PRS C" — In Default. For short-term issuances, they are from "PRS I" Best Grade to
"PRS 6" — In Default. For long-term issuances, they are from "PRS Aaa" to "PRS C".

COST OF CAPITAL

Cost of capital is the weighted average cost of a firm's long-term capital considering the
different sources thereof. Thus, it is computed based on the capital structure and the cost of
each component thereof. It is used as a benchmark in evaluating activities/projects such as in
the use of working capital, acquisition/replacement of plant, property and equipment, source-
of-financing decisions, and acquisitions of other business entities. It is often used as the
minimum desired rate of return in making capital investment decisions. It is computed as
follows:

Cost of capital = Component % x Specific Cost

Specific cost of each source of long-term capital:

Loans payable Interest rate x (I-tax rate)

Preferred stock Dividend rate/lssue or market price per share
Common equity Earnings per share/Market price per share

Common equity is the total of all accounts related to common stock. In the absence of any
statement to the contrary, it is assumed that the retained earnings balance is net of dividends
for preferred stock.
Example: The capital structure of ADF corporation is as follows:
Loans payable (15%)………………………………………P200, 000
10% Preferred
stock………………………………………...200,000
Common stock………………………………………………300,000
 Retained earnings …………………………………………. 100,000
Total…………………………………………………………P800,000

Income tax rate is 35%. Earnings per share amount to P50 and market price per share of
common stock is P400.

Cost of capital is computed as follows:

Components % Specific cost Weighted cost

Loans Payable P200,000 25% 15% x (1-35%) 9.75% 2.44%

Preferred Stock 200,000 25 10.00 2.50
%
Common Equity 400,000 50 P50/P400 12.50 6.25
P800,000 100% % 11.19%
For ADF Corp. to maintain the market value of its capital stock, it must realize 11.19% on
its projects.

PRACTICES THAT REDUCE REQUIREMENT FOR LONG-TERM

FUNDS

The following practices result in this advantage:

 Leasing instead of buying. The company avoids paying for purchase cost and instead,
pays periodic rentals. Even if the total of the periodic rentals exceed purchase cost, the
lease alternative may prove to be more advantageous when the ease of burden on long-
term capital, time value of money and cost of capital (including opportunity cost) are
taken into consideration.

 Sale and leaseback. This refers to selling the property being used and subsequently
leasing them back so that the seller is able to continue using the same property. He
benefits from the use of the proceeds from such sale and undertakes to pay periodic
rentals.

 Buying on installment basis instead of on cash basis. This reduces the burden on long-
term capital in as much as the periodic installments may be paid out of cash inflows
from operations. In case of financial reverses, installment payments on real property
already paid for a minimum of two (2) years have to be partly refunded. (RA6552,
otherwise known as the Maceda Law).

 Lease-Purchase. This refers to a contract whereby the lessee pays rentals that are partly
applied to purchase price of the subject property. The lessee/buyer may therefore make
the periodic payments out of cash inflows from the use of the property.

SCHEDULE OF AMORTIZATIONS

In availing of the different sources of short-term and long-term financing, periodic

amortizations vary depending on how interest is computed. Interest may be long-end, short-
end or included already in equal periodic payments.

Long-end interest is based on the balance of the principal between periodic payments.
 Short-end interest is based on the installment due from the date of the contract. Under
the annuity method, equal periodic payments include both interest and principal.

Example: The invoice price of an item is P10,000 and is payable in 5 monthly installments.
Interest is 2% per month.

(Refer to the next page for sample illustrations)

The schedules of amortization would be as follows:

1. Interest is based on balance of principal between periodic payments (long-end):
Payments

End of Total Interest Principal Balance of

Month Principal
1 P 2,200 P 200 P 2,000 P 10,000
2 2,160 160 2,000 8,000
3 2,120 120 2,000 6,000
4 2,080 80 2,000 4,000
5 2,040 40 2,000 2,000
P10,600 P 600 P10,000 0

2. Interest is based on installment due from date of the contract (short-end):

Payments

End of Total Interest Principal Balance of

Month Principal
P40 P2,000 P10,000
1 P2,040
80 2,000 8,000
2 2,080
3 2,120 120 2,000 6,000
4 2,160 160 2,000 6,000
5 2,200 200 2,000 4,000

PI0,600 P600 P10,000 0

3. Interest is part of the equal periodic installments (annuity method):

End of Month Total Interest Principal Balance
Principal
P 10,000.00
1 P 2,121.58 P 200.00 P 1,921.58 8,078.42
2 2,121.58 161.57 1,960.01 6,118.41
 3 2,121.58 122.37 1,999.21 4,119.20
4 2,121.58 82.38 2,039.20 2,080.00
5 2,121.58 41.58 2 080.00 0
P10,607. P607.90 P10,000
90
Monthly amortization = Principal/Present value of an annuity of 1 for 5 period at 2%
= P10,000/4.713458
= P2,121.58

OTHER SOURCES OF FUNDS

Although a business entity should maintain its relationship with the different sources of
funds, it should also look into other means of raising funds such as the following:

 Idle facilities. Facilities not being used in operations and from which no income is
derived may be leased out or sold.

 Funds set aside for special purposes in excess of estimated requirements Amounts in
excess of estimated requirements for plant expansion, liquidation of long-term debt and
for contingencies may be transferred back to working capital.

 Long-term investments. These may be in the form of real estate, stocks and bonds of
other companies. They may be disposed of and in the of real estate, a second option
would be to lease it out other parties.

ASSESSMENT

I. TRUE OR FALSE
Write your answers in the space provided before the number.

__________1. Selling receivables provides the seller with additional liquidity although the
proceeds therefrom may be much smaller than what can be collected directly from
the debtors (customers).
__________2. Unsecured loans are charged lower interest rates as compared to secured loans
because of the minimum paper work they entail.
__________3. One way of raising funds is to dispose of non-productive assets and duplicate
machinery, equipment and furniture.
__________4. Interest rates on loans are higher than the prime interest rate.
__________5. Effective interest rate is higher than the nominal rate on a loan that is discounted.

II. IDENTIFICATION

_______________1. Known as debt capital.

_______________2. It is used as a benchmark in evaluating activities/projects.
_______________3. Refers to the mix of debt capital and equity capital.
_______________4. This term refers to ownership in a corporation.
_______________5. based on the installment due from the date of the contract.

III. MULTIPLE CHOICE

Justify your answer.
1. Andalucia Corp. made purchases of P26,144, 3/10, N/50. It intends to borrow from
CBTC at 18% interest plus service charges of P120 to be able to avail of the discount.
Should the company borrow and avail of the discount or forego the discount? What
would be the differential cost percentage?

a. Borrow and avail of the discount; 6.79%

b. Forego the discount; 12.5%
c. Borrow and avail of the discount; 5.12%
d. None of the above.

2. From which of the following banks would cost be lower?

Bank X - 22% interest payable at maturity
Bank Y - 20% interest on a discount basis

a. Bank Y, it is lower by 2% c. Bank X, it is lower by 5%

b. Bank X, it is lower by 3% d. None of these

Solution:

FEEDBACK

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REFERENCE

Dr. Flores, M. (2016). Business Finance for Senior High School. Unlimited Books & Publishing
Inc., Room 215 ICP Bldg., Cabildo ST., Intramuros, Manila, pages 147-157.

Personal Finance Activities

© 2013 Cengage Learning.