Sources of Finance

Companies always seek sources of funding to grow their business. Funding,

also called financing, represents an act of contributing resources to finance a
program, project, or need. Funding can be initiated for either short-term or
long-term purposes. The different sources of funding include:

● Retained earnings

● Debt capital

● Equity capital

● Other sources, such as crowdfunding

Retained Earnings

Businesses aim to maximize profits by selling a product or rendering a

service for a price higher than what it costs them to produce the goods. It is
the most primitive source of funding for any company.

After generating profits, a company decides what to do with the earned

capital and how to allocate it efficiently. The retained earnings can be
distributed to shareholders as dividends, or the company can reduce the
number of shares outstanding by initiating a stock repurchase
campaign.Alternatively, the company can invest the money into a new
project, say, building a new factory, or partnering with other companies to
create a joint venture.

Debt Capital

Companies obtain debt financing, or debt capital, privately through bank

loans. They can also raise capital by issuing debt to the public.

In debt financing, the issuer (borrower) issues debt securities, such as

corporate bonds or promissory notes. Debt issues also include debentures,
leases, and mortgages.

Companies that initiate debt issues are borrowers because they exchange
securities for cash needed to perform certain activities. The companies will
be then repaying the debt (principal and interest) according to the specified
debt repayment schedule and contracts underlying the issued debt
securities.
The drawback of borrowing money through debt is that borrowers need to
make interest payments, as well as principal repayments, on time. Failure to
do so may lead the borrower to default or bankruptcy.

Equity Capital

Equity capital, or equity financing, refers to the funds a company raises by

offering ownership stakes, either publicly or privately, in exchange for
investment. Compared to debt capital funding, companies with equity capital
don’t need to make debt and interest payments. Instead, company profits
are shared with investors.

Stock Market

Companies can raise funds from the public by offering ownership stakes in
the form of stock. These ownership stakes are represented by shares issued
to a wide range of institutional and individual investors. When investors
purchase these shares of stock, they become shareholders.

However, one disadvantage of equity capital funding is sharing profits among

all shareholders in the long term. More importantly, shareholders dilute a
company’s ownership control as long as it sells more

Private Market

Private equity capital is secured from private investors, such as venture

capitalists or private equity firms. Companies raise funds from private
investors in exchange for significant ownership stakes, often with a hands-on
role in the company’s strategic direction. Private equity and venture capital
are common sources of equity capital for companies that are not yet publicly
traded or are in the early stages of development.

Crowdfunding

Crowdfunding represents a process of raising funds to fulfill a certain project

or undertake a venture by obtaining small amounts of money from a large
number of individuals. The crowdfunding process usually takes place online
and is a common source of finance for startup businesses

Donations

Donations are a common way for nonprofits and social enterprises to raise
the funding they need to carry out their mission without the pressure of
generating profits. Donors who give money to nonprofits or social enterprises
are motivated by the cause rather than financial returns.
Government Grants and Subsidies

Grants and subsidies are examples of financing provided by government

agencies to support specific projects, initiatives, or sectors that align with
public policy goals. Grants commonly provide funding for research,
education, environmental protection, or community development.

Subsidies are financial assistance programs designed to lower the cost of

goods or services,making them more accessible or promoting particular
industries. Agriculture is an example of an industry that frequently receives
government subsidies.

Cost of capital

Cost of capital refers to the return a company expects on a specific

investment to make it worth the expenditure of resources. In other words,
the cost of capital determines the rate of return required to persuade
investors to finance a capital budgeting project.

The cost of capital is heavily dependent on the type of financing used in the
business. A business can be financed through debt or equity. However, most
companies employ a mixture of equity and debt financing. Therefore, the
cost of capital comes from the weighted average cost of all capital sources.

The cost of capital is an important factor in determining the value of a

company and influence decisions in areas such as investments, financing
and risk management. The cost of capital helps business determine if funds
being invested is beneficial. If the return on an investment is greater than
the cost of capital, that means investment is righteous and will benefit the
company's balance sheets. On the other hand, an investment whose returns
are equal to or lower than the cost of capital indicates that the investment is
not wise to yield profit. Thus, it allows company make informed decisions
about the funds and investments.

Cost of Debt

The cost of capital becomes a factor in deciding which financing track to

follow: debt, equity, or a combination of the two.

Early-stage companies rarely have sizable assets to pledge as collateral for

loans, so equity financing becomes the default mode of funding. Less-
established companies with limited operating histories will pay a higher cost
for capital than older companies with solid track records.
The cost of debt is merely the interest rate paid by the company on its debt.
However, since interest expense is tax-deductible, the debt is calculated on
an after-tax basis as follows:

Cost of debt= Interest expense/ Total Debt ×(1−T)

where:

Interest expense=Int. paid on the firm’s current debt

T=The company’s marginal tax rate

Cost of Preference Share : To determine cost of preference share we need

use the following formula:

Kp= (D+ (R-P)/N)///R+P/2

D= Dividend Per share

R= Redeemable price of Preference Share

P= Net Sale proceeds per share

N= No of years / time period for redemption of Preference share.

Cost of equity

Cost of equity refers to the return a company requires to determine if capital

requirements are met in an investment. Cost of equity also represents the
amount the market demands in exchange for owning the asset and therefore
holding the risk of ownership.

Ke = D/P + g

In this formula:

● D = Annual Dividend

. P = Current Market Price

● G= Growth Rate

Cost of Capital (WACC)

Weighted average cost of capital (WACC) is a company's average after-tax

cost of capital from all sources,including common stock, preferred stock,
bonds, and other forms of debt. It represents the average rate that a
company expects to pay to finance its business.

●
In this formula:

● E = the market value of the firm's equity

● D = the market value of the firm's debt

● V = the sum of E and D

● Re = the cost of equity

● Rd = the cost of debt

● Tc = the income tax rate

Financial Leverage

Financial leverage is the concept of using borrowed capital as a funding

source. Leverage is often used when businesses invest in themselves for
expansions, acquisitions, or other growth methods.

Leverage is also an investment strategy that uses borrowed money—

specifically, the use of various financial instruments or borrowed capital—to
increase the potential return of an investment.

Leverage is using debt or borrowed capital to undertake an investment or

project. It is commonly used to boost an entity's equity base. The concept of
leverage is used by both investors and companies:

● Investors use leverage to significantly increase the returns that can be

provided on an investment. They leverage their investments using various
instruments, including options, futures, and margin accounts.

● Companies can use leverage to finance their assets. In other words,

companies can use debt financing to invest in business operations to
influence growth instead of issuing stock to raise capital.

Financial Leverage Ratio

The financial leverage ratio is an indicator of how much debt a company is

using to finance its assets. A high ratio means the firm is highly levered
(using a large amount of debt to finance its assets). A low ratio indicates the
opposite

Operating Leverage Formula

The operating leverage formula measures the proportion of fixed costs per
unit of variable or total cost. When comparing different companies, the same
formula should be used.

Debt Ratio

You can analyze a company's leverage by calculating its ratio of debt to

assets. This ratio indicates how much debt it uses to generate its assets. If
the debt ratio is high, a company has relied on leverage to finance its assets.
A ratio of 1.0 means the company has $1 of debt for every $1 of assets. If it
is lower than 1.0, it has more assets than debt—if it is higher than 1.0, it has
more debt than assets

Debt Ratio = Total Debt ÷ Total Assets

Debt-to-Equity (D/E) Ratio

Instead of looking at what the company owns, you can measure leverage by
looking strictly at how assets have been financed. The debt-to-equity (D/E)
ratio is used to compare what the company has borrowed to what it has
raised from private investors or shareholders.

Debt-to-Equity (D/E) Ratio = Total Debt ÷ Total Equity

A D/E ratio greater than 1.0 means a company has more debt than equity.
However, this doesn't necessarily mean a company is highly leveraged. Each
company and industry typically operates in a specific way that may warrant
a higher or lower ratio.

For example, start-up technology companies may struggle to secure

financing and must often turn to private investors. Therefore, a debt-to-
equity ratio of .5 ($1 of debt for every $2 of equity) may still be considered
high for this industry.