EXERCISES

Short Answer Questions

1. What is business finance? Why do businesses need funds? Explain.

Answer: Business finance refers to “the requirements of funds by business to carry out its various activities.” It is considered the “life blood of any business.” Businesses need funds from the very beginning, when an entrepreneur decides to start a business. Funds are required for:

Fixed Capital Requirements: To purchase fixed assets like land, building, plant, machinery, and furniture, which remain invested for a long period.

Working Capital Requirements: For day-to-day operations, including holding current assets like raw materials and bills receivables, and meeting current expenses like salaries, wages, taxes, and rent. Additionally, funds are needed for growth, expansion, upgrading technology, building inventories, meeting current debts, or relocating.

2. List sources of raising long-term and short-term finance.

Answer:

Long-term Sources (exceeding 5 years):

• Shares (Equity and Preference Shares)
• Debentures
• Long-term borrowings and loans from financial institutions
• Retained Earnings
• International Agencies and Development Banks
• International Capital Markets (GDRs, ADRs, FCCBs)

Short-term Sources (not exceeding 1 year):

• Trade Credit
• Loans from Commercial Banks (for short term needs)
• Commercial Papers
• Public Deposits (can also be medium-term)

3. What is the difference between internal and external sources of raising funds? Explain.

Answer:

Internal Sources: These are funds “generated from within the business.” Examples include accelerating the collection of receivables, disposing of surplus inventories, and ploughing back its profit (retained earnings). These sources can generally fulfill only limited business needs.

External Sources: These are funds that “lie outside an organisation, such as suppliers, lenders, and investors.” They are used when large amounts of money are required. External funds can be costly and may require mortgaging assets as security. Examples include the issue of debentures, borrowing from commercial banks and financial institutions, and accepting public deposits.

4. What preferential rights are enjoyed by preference shareholders. Explain.

Answer: Preference shareholders enjoy two main preferential rights over equity shareholders:

Preferential Right to Dividend: They have the right to receive a fixed rate of dividend before any dividend is paid to equity shareholders.

Preferential Right to Capital Repayment: At the time of the company’s liquidation, they have the right to receive their capital back after the claims of the company’s creditors have been settled, but before equity shareholders.

5. Name any three special financial institutions and state their objectives.

Answer:

1. International Finance Corporation (IFC): An international agency that provides long-term project finance and foreign currency loans, aiming to foster sustainable economic growth in developing countries by financing private sector investment.
2. Asian Development Bank (ADB): An international development bank that provides funds and technical assistance for development projects in Asia and the Pacific, aiming to reduce poverty and improve the quality of life.
3. International Bank for Reconstruction and Development (IBRD – World Bank): An international development bank that provides financial and technical assistance to developing countries around the world, primarily for long-term projects aimed at reducing poverty and supporting development. (Note: The chapter also mentions “specialised financial institutions” generally and ICICI in Box A as an example of an institution providing lease financing, implying their objective is financial assistance to businesses).

6. What is the difference between GDR and ADR? Explain.

Answer:

Global Depository Receipts (GDRs): These are financial instruments denominated in US dollars, issued by an Indian company, but held by an overseas depository bank which then issues the receipts to foreign investors. They are traded on international stock exchanges like the London Stock Exchange or Luxembourg Stock Exchange. GDR holders typically do not get direct voting rights.

American Depository Receipts (ADRs): These are similar to GDRs, but they can only be issued to American citizens and are traded only in the US financial markets. Their issuance and trading are subject to the regulations of the US Securities and Exchange Commission (SEC), and they are traded on major US stock exchanges like NYSE or NASDAQ. The key difference lies in the market and investor base: GDRs are global and can be traded in multiple international markets, while ADRs are specific to the US market and US investors.

Long Answer Questions

1. Explain trade credit and bank credit as sources of short-term finance for business enterprises.

Answer:

Trade Credit: This is the credit “extended by one trader to another for the purchase of goods and services.” It means that a business can purchase supplies (like raw materials or inventory) from its suppliers without immediate payment. The payment is deferred to a future date. It appears in the business’s books as ‘sundry creditors’ or ‘accounts payable’. Trade credit is a widely and commonly used source of short-term financing because it is often readily available, convenient, and does not typically require any charge on the firm’s assets. The volume and period of trade credit depend on the buyer’s reputation, the seller’s financial position, the volume of purchases, and market competition.

Bank Credit (Short-term): Commercial banks play a vital role by providing various forms of short-term finance to businesses. These include “cash credits, overdrafts, and purchase/discounting of bills.”

• Cash Credit: A borrowing arrangement where a business can withdraw money up to a certain limit against current assets or other securities.
• Overdraft: Allows a business to withdraw more money than available in its current account, up to an agreed limit, for a short period.
• Purchase/Discounting of Bills: Banks can purchase or discount bills of exchange, providing immediate funds against future receivables. Bank credit is a flexible source, providing timely assistance. However, it’s generally not a permanent source, and extensions or renewals can be uncertain. Banks also conduct detailed investigations and often require security, which can make the process more difficult for businesses.

2. Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.

Answer: A large industrial enterprise requiring substantial capital for modernization and expansion, which are typically long-term needs, has access to a wide range of sophisticated funding sources:

1. Equity Shares: This is a primary source of “long-term capital” for large companies. Issuing equity shares allows a company to raise ownership capital that does not need to be repaid until liquidation. It enhances creditworthiness and does not create a fixed financial burden, offering flexibility.
2. Retained Earnings: For an established large enterprise, ploughing back profits (retained earnings) is a “permanent source of funds” with no explicit cost. It offers greater operational freedom and can be a significant internal source for funding growth.
3. Debentures: These are important instruments for “raising long term debt capital.” Debentures allow the company to borrow large sums at a fixed interest rate, without diluting ownership or control. They are attractive to investors seeking fixed income and their interest payments are tax-deductible for the company.
4. Financial Institutions: Government-established financial institutions (like development banks, including IFC, ADB, IBRD, and domestic institutions like ICICI) are crucial. They provide “both owned capital and loan capital for long and medium term requirements.” These institutions specialize in large-scale project finance for “expansion, reorganisation and modernisation” and also offer expert professional advice.
5. International Capital Markets (GDRs, ADRs, FCCBs): Large industrial enterprises can tap into global capital by issuing Global Depository Receipts (GDRs) and American Depository Receipts (ADRs) to raise equity-like funds from foreign investors. Foreign Currency Convertible Bonds (FCCBs) offer a hybrid debt-equity option in foreign currency, providing access to international debt markets with potential for equity conversion. These allow access to vast pools of capital for ambitious expansion plans.
6. Commercial Banks (Term Loans): While also providing short-term funds, commercial banks offer “term loans” specifically for medium to long-term needs, which can be utilized for modernization and expansion projects.

3. What advantages does issue of debentures provide over the issue of equity shares?

Answer: The issue of debentures offers several advantages over the issue of equity shares, particularly from the company’s perspective:

1. No Dilution of Control: Debenture holders are creditors, not owners, and therefore “do not carry voting rights.” This means that financing through debentures does not dilute the equity shareholders’ control or management of the company.
2. Fixed and Predictable Cost: Debentures bear a “fixed rate of interest.” This makes the cost of financing predictable, especially suitable for companies with stable earnings. Equity dividends, on the other hand, fluctuate with profits.
3. Tax Deductibility of Interest: The interest paid on debentures is treated as an expense and is “tax deductible.” This reduces the company’s taxable income and effectively lowers the actual cost of borrowing compared to equity dividends, which are paid out of after-tax profits.
4. No Profit Sharing: Debenture holders are entitled only to their fixed interest payments and repayment of principal. They “do not participate in company profits,” unlike equity shareholders who are residual owners and share in the company’s success.
5. Preference for Fixed Income Investors: Debentures are preferred by investors seeking “fixed income at lesser risk,” which helps the company attract a different segment of investors than those interested in equity.
6. Flexibility for Equity Holders: By issuing debentures, the company can avoid issuing more equity, which means the “earning per share” for existing equity shareholders might be higher during profitable times, as fewer equity shares are outstanding.
7. No Charge on Assets (for unsecured): While some debentures are secured, others are unsecured, meaning they “do not create any charge on company assets,” leaving assets free to be used as security for other loans.

4. State the merits and demerits of public deposits and retained earnings as methods of business finance.

Answer:

Public Deposits

Merits:

1. Simple Procedure: The process of inviting public deposits is generally simpler with “few restrictive conditions.”
2. Lower Cost: They are often a “lower cost” source of finance compared to borrowings from commercial banks or financial institutions.
3. No Charge on Assets: Public deposits typically “do not create any charge on company assets,” allowing assets to be used as security for other loans.
4. No Control Dilution: Depositors do not have voting rights, so the control of the company is “not diluted.”

Demerits:

1. Difficulty for New Companies: “New companies find it difficult to raise funds” through public deposits due to lack of public trust and reputation.
2. Unreliable Source: The public’s response can vary, making it an “unreliable source” of finance.
3. Collection Difficulty: Collecting large sums in deposits from numerous individuals can be “difficult.”

Retained Earnings

Merits:

1. Permanent Source: Retained earnings are a “permanent source of funds” available to the business as long as it exists.
2. No Explicit Cost: There are “no explicit cost” like interest or dividend payments, nor any floatation costs associated with raising external capital.
3. Operational Freedom: It provides greater “operational freedom and flexibility” as there are no external lenders or shareholders imposing conditions.
4. Absorbs Losses: It “enhances capacity to absorb unexpected losses,” providing a financial cushion.
5. May Increase Share Price: Reinvestment of profits can lead to higher future earnings, which “may increase the market price of equity shares.”

Demerits:

1. Shareholder Dissatisfaction: “Excessive ploughing back” may lead to lower dividends, causing “shareholder dissatisfaction.”
2. Uncertain Source: It is an “uncertain source” of finance because the amount available depends entirely on the company’s profits, which can fluctuate.
3. Sub-optimal Use: The “opportunity cost” of retained earnings is often not recognized, which can lead to “sub-optimal use of funds” if not invested wisely.

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Business Studies Chapter 8 Solutions NCERT Class 11th – Sources of Business Finance