Sources of Finance

Sources of Finance
2
LO 1 EQUITY
LO 2 DEBT
LO 3 ISLAMIC FINANCE
LO 4 OTHER COMMON SOURCES OF FINANCE
CHAPTER-02 Sources of Finance
CORE SOURCES OF FINANCE

An important aspect of financial management is the choice of methods of financing for a company’s assets.
Companies use a variety of sources of finance and the aim should be to achieve an efficient capital structure that
provides:
 A suitable balance between short-term and long-term funding.
 Adequate working capital.
 A suitable balance between equity and debt capital in the long-term capital structure
Factors considered before selecting source of finance:

Before selecting the source of finance the company should consider different factors that are:
Amount required For example access to long-term bank lending may be restricted due to the amount of
risk that banks are willing to take. The company may be required to raise new long-term
capital through the sale of equity shares (see below).
Cost The company should consider both the on-going servicing cost and the initial
arrangement cost for its financing. For example, the cost of both raising and servicing
equity may be high as shareholders accept high risk in return for the promise of higher
rewards (dividends).
Duration Broadly speaking short-term financing is used to fund short-term assets and long-term
financing used to fund long-term assets.
Security Debtholders demand security which company need to consider.
Flexibility The Directors should consider balancing risk, cost and flexibility. For example, in a year
with low profits (or even a loss) the company could decide not to pay a dividend to the
shareholders. However, most debt financing requires the payment of interest
irrespective of company performance.
Repayment The company needs to carefully forecast future cash flows in order to ensure it is able
to repay debt as it falls due. For example, a company should ensure it generates enough
cash to repay a 10- year bank-loan in 10-years’ time on the due date.
Impact on financial Stakeholders such as equity investors and the providers of debt finance will often
statements analyses a company’s financial statements to help them assess the risk involved in
financing the company. Therefore, the company should consider the impact that its
financial management decisions might have on its financial statements and the message
that sends to providers of finance. The details of sources of finance are explained in next
section.
Voting control A large issue of shares to new investors could alter the voting control of a business. If
the founding owners hold over 50% of the equity they may be reluctant to sell new
shares to outside investors as their voting control at the AGM may be lost.
There are two main sources of finance:
1. Equity
2. Debt
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LO 01: EQUITY
Providers of equity are the ultimate owners of the company and exercise control through the voting rights
attached to shares.
Equity shareholders gain a return on their investment in two ways:

 Capital gains – The value of their share in the company increases as the value of the company increases.
 Dividends – Companies return cash to shareholders through the payment of dividends. Dividends are
typically paid once or twice per year.
The cost of equity is higher than other forms of finance as the equity holders carry a high level of risk, and therefore
command the highest of returns as compensation.
New issues to new investors will dilute control of existing owners. Finance is raised through the sale of shares to
existing or new investors (existing investors often have a right to invest first which is called pre-emption rights).
Issue costs can be high. The company issues two types of shares to raise equity finance:
Comparison of ordinary shares and preference shares

The company can issue ordinary shares as well as preference shares to raise equity finance but the characteristics
of both types of shares are different as:
Feature Ordinary shares Preference shares

Dividend rate Variable – higher in a good year, lower in a bad Fixed e.g. 4% per annum
year
Dividend Paid only if there are spare funds after the Receives the dividend before ordinary
distribution payment of a preference dividend shareholders (therefore lower risk)
Liquidation The last to be repaid in a liquidation Repaid before (in preference to) the
ordinary shareholders
Voting rights Normally receive the right to vote on major Typically receive no right to vote on
decisions. Each ordinary share would attract company decisions.
one vote.
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Five principal methods for a company to raise equity finance:
(i) Initial public offer (IPO):

A public offer refers to the process in which a company offers its shares for sale to private and/or institutional
investors. The first time the company offers its shares for sale is called an initial public offer. IPOs maybe done by
adopting any of the following strategies.
Fixed Price Offer: Price of the share is fixed and investors are asked to deposit money into banks for which they want to
buy shares
Offer for Sale by Tender: In this process, shareholders themselves bid to buy shares at the price of their own choice. Final
price at which shares are sold to shareholder is determined by the demand of shares and despite different bids received
all the shares are issued at one single price determined by company after evaluating the tenders received.
Mechanism:
An initial public offer normally involves the acquisition (or underwriting) by an issuing house of a large block of
shares of a company. They will then offer them for sale to the general public and/or other investors. The issuing
house is normally a merchant bank or a syndicate of banks.
Key Features:
Shares are normally offered at a fixed price which is decided by the company and its broker. The issue price needs
to be attractive to prospective shareholders in order to incentivize them to invest. IPOs are normally the most
expensive route to market and are therefore commonly seen with larger companies looking to raise substantial
amounts of capital.
(ii) Private placing:

Placing is a lower risk and lower cost method of issuing shares. Placing is suitable when issuing a lower volume of
shares than in an IPO.
Mechanism:
With a private placing an issue of equity shares is ‘placed’ by the company with one or more institutional investors
through a broker. Unlike with an IPO it is not open to the general public.
There may be some limits on the maximum amount of an issue that can be placed. This will depend on local law.
Placing is popular with listing on the AIM (Alternative Investment Market). AIM is an alternative to the main stock
exchange and is more suited to companies with lower capitalization levels than the very largest of companies.
Key Features:
A private placing normally results in a narrower shareholder base and potentially lower liquidity in the shares once
the company has been admitted to a market. For such issues the costs of an IPO such as advertisement, marketing
and underwriting costs are unjustified by the size of issue.
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(iii) Introduction:
By becoming listed, a company gets access to larger pool of finance and is allowed to offer its share to public for
sale.
An ‘introduction’ describes when shares in a large company are already widely held by the public (typically at least
25% of a company’s ordinary share capital - so that a market for the shares already exists) and the company wants
its shares to be publicly tradable on a recognized stock market.
Mechanism:
In introduction, no new shares are issued to general public. Rather, existing shares are registered on stock
exchange to increase their marketability and public trading so that company can have better access to capital in
future.
Now any company wishing to become quoted may fall under any of the following categories:
Where 25% shares of the company are already with public (sold through door-to-door convincing):
Such companies can easily apply for the listing just meeting the regulatory requirement, paying the due fees and submitting
the desired documents. And on satisfaction with the documents, Stock Exchange will approve the listing the company
becomes listed. As in this procedure no finance is raised, it is termed as INTRODUCTION.
Where 25% shares are not held with the public:

Such companies shall comply with the regulatory requirement and along with the listing application, shall submit to Stock
Exchange their willingness to sell at least 25% share to public (or if some shares are already issued, then balance) in the
shape of prospectus. If Stock exchange is satisfied with the documents will approve the listing along with the prospectus,
which is immediately issued to public as public offer. In this manner, along with listing, company is also able to raise finance.
(i) Right Issue:

A rights issue is an offering of rights to the existing shareholders of a company that gives them an opportunity to
buy additional shares directly from the company at a discounted price rather than buying them in the secondary
market.
Mechanism:
This is when a company issues new shares to its existing ordinary shareholders. Each shareholder has the right to
buy new shares in proportion to their existing shareholding – e.g. “1 for 1” which means a shareholder can buy
one new share for each one they already own.
Key Features:
This is a Pre-Emptive right of shareholder. Shareholders not wishing to take up their rights can sell them on stock
market. It is cheaper as compare to public offering and rarely fails. It is made at discretion of directors without
consent of shareholders or stock exchange.
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(ii) Bonus Issue

A bonus issue is a method of altering the share capital without raising cash. The company capitalizes part of its
reserves by making a bonus issue to the existing shareholders.
Mechanism:
With a bonus issue no new capital is raised. This has the effect of increasing the number of shares in circulation
(and thus increase liquidity) although as no new capital was raised the average value of the greater number of
shares will fall proportionally. This concept is also known as stock dividends and capitalization of earnings as it
converts retained earnings into shares capital.
Key Features:
It enhances shareholder value by increasing the number of shares held without diluting ownership.
This is not a source of new finance for the company.
Unlike traditional equity offerings, bonus issues avoid underwriting fees and other associated costs, offering a
more efficient means of accessing capital while diluting existing shareholders' ownership minimally.
Difference between Right Issue and Bonus Issue:

Right Shares Bonus Shares
Issued to existing shareholders in proportion to their Issued to existing shareholders without any additional
existing holdings. cost.
In case of right issue, the company issues shares to its In case of bonus issue the company issue shares by
existing shares holders in exchange of consideration capitalizing its existing reserves that increase the
that increases the assets of company normally in cash. shares of company without increasing the assets of
company.
For example, if company ‘A’ limited issued 5,000 right
shares to existing shares holders of Rs. 100 per share For Example, if company ‘A’ issues 5,000 bonus shares
then at the same time it increases the share capital as to its existing shares holders then it only increasing its
well as cash of the company by Rs. 500,000. share capital by Rs. 500,000.
Shareholders have the right to subscribe to the new Shareholders do not have the right to subscribe to the
shares. new shares.
Dilutes the ownership of existing shareholders. Does not dilute the ownership of existing shareholders.
Raises capital for the company. Does not raise capital for the company.
Can be issued at a premium or discount to the current Usually issued at the face value or the par value of the
market price. shares.
Advantages and disadvantages of Equity Sources of Finance:

Equity financing is a method of raising capital for a business by selling shares of ownership, typically in the form
of stocks, to investors. While equity financing offers several advantages, it also comes with its own set of
disadvantages. Here's an introductory discussion about the advantages and disadvantages of equity sources of
finance:
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Advantages Disadvantages
Less burden: Share profit:
With equity financing, there is no loan to repay. The Your investors will expect and deserve a piece of your
business doesn’t have to make a monthly loan payment profits. However, it could be a worthwhile trade-off if
which can be particularly important if the business you are benefiting from the value they bring as
doesn’t initially generate a profit. This gives freedom to financial backers and/or their business acumen and
channel more money into your growing business. experience.
Credit issues gone: Loss of control:

If you lack creditworthiness through a poor credit The price to pay for equity financing and all of its
history or lack of a financial track record equity can be potential advantages is that you need to share control
preferable or more suitable than debt financing. of the company.
Learn and gain from partners: Potential conflict:

With equity financing, you might form informal Sharing ownership and having to work with others
partnerships with more knowledgeable or experienced could lead to some tension and even conflict if there
individuals. Some might be well-connected, allowing are differences in vision, management style and ways
your business to potentially benefit from their of running the business. It can be an issue to consider
knowledge and their business network. carefully.
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LO 02: DEBT
Debt finance describes finance obtained when a company borrows money in exchange for the payment of interest.
Debt can be categorized between short-term and long-term depending on time between issuance and maturity.
Long Term Short Term

Long term finance is used for major long-term Short term finance is used to fund short-term working
investments and is usually more expensive and less capital requirements and is usually cheaper and
flexible. flexible.
 Bonds, loan stock, debentures, loan notes,  Overdraft
commercial paper  Short-term bank loan
 Euro bonds  Certificate of deposit
 Convertible bonds and warrants  Treasury-bill
 Long-term bank loan  Trade credit
However, above classification is not a perfect science. Debt is also classified between:
Redeemable debt Irredeemable debt
Redeemable debt will be repaid and cancelled. Irredeemable debt is (in theory) never repaid. The debt
Redeemable debt is common as compared to buyer benefits solely from the interest payments they
irredeemable debt. receive.
Long Term Sources of Finance:
(i) Euro Bonds:

A Eurobond is a bond denominated in a currency that is not native to the country where it is issued. Eurobonds
are named after the currency they are denominated in. For example:
 A Eurodollar bond could be issued anywhere outside the USA.
 A European bond could be issued anywhere outside Japan.
 A Euro sterling bond could be issued anywhere outside the UK.
Eurobonds are normally issued by an international syndicate and are an attractive financing tool as they normally
have small par values and high liquidity. Eurobonds give the issuer flexibility to choose the country in which to
offer their bond according to the country’s regulatory constraints.
(ii) Bonds, Loan Notes, Debentures, Commercial Paper and Loan Stock:
In today’s markets the terms bonds, loan note, debentures and commercial paper are often used interchangeably
although the legal definition can vary between jurisdictions. The most commonly accepted differences between
the instruments are:
 Loan Note – short term with maturity of less than 12 months in the case of government notes, or less than 5
years for corporate loan notes
 Debenture – unsecured long-term loan
 Bond – secured long-term loan (typically between 5 and 20 years)
 Commercial Paper – very short term with a maturity of less than 9 months
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Mechanism:
The basic principle of bonds, loan notes, debentures, commercial paper and loan stock is same. An investor loans
money to a company in exchange for receiving interest and the subsequent repayment of loan.
Key Features:
All these instruments have a ‘par value’ that signifies the debt owed by a company to the instrument holder.
These instruments can be bought and sold on the capital markets. These markets are known as secondary markets,
since they trade debt that has already been issued. The market value may be different from the par value. This is
because the market value depends upon market forces and interest rate expectations.
Interest is usually paid every year or every six months and is calculated on the par value.
Usually the interest rate is fixed: however, it may also be floating related to the current market interest rate.
(For the rest of this section we will use the generic term ‘Loan Stock’ to include bonds, loan notes, debentures and commercial paper.)
Some Key Concepts Related to Loan Stock:

 Market value of loan stock:
Debt is usually issued at a fixed value of Rs. 100, called par value. The interest rate, known as the coupon rate, is
set when the debt is issued based on current market conditions. Changes in market and company conditions will
affect the bond's market value over time, but the coupon rate remains fixed as a percentage of the par value.
The fundamental principle for valuing bonds based on future expected returns is:
Value of debt = (Interest earnings x annuity factor) + (Redemption value x Discounted cash flow factor)
OR
M.V. of debt= P.V of interest payments+ P.V of redemption value
The market will also take account of other market factors such as reputation, interest rate expectations and risk
when valuing debt.
 Charge (mortgage) on loan stock:
Loan stock may be secured through a fixed or floating charge on assets. A fixed charge may be on
specific assets such as land and buildings. The specified assets cannot be sold while the loan is outstanding. A
floating charge is a charge on a class of assets, such as inventory, receivables or machinery. Sale of some assets
of the class is permitted. When a fault arises, such as a default in payment of interest, a floating charge converts
into a fixed charge on the specific class of assets.
 Interest rate on loan stock:
Interest rate can be fixed (agreed at the outset) or floating (Depending on prevailing market interest rates).
Example # 01: (ICAP Example # 01)

If ‘A’ limited has the following data
Interest per annum Rs. 490
Required rate of return 10%
Loan agreement 5 Years
Interest rate 7% p.a
Redemption value 7% Premium
Loan amount 7,000
Required: In the above context, find the market value of debt.
Answer:
Market value of debt = (490 x 3.79) + (7,490 x .621)
= 1,857 + 4,651 = Rs. 6,508
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Advantages disadvantages of Deep discounted bonds and Zero coupon bonds:

Zero coupon bonds can be used to raise cash The advantage for lenders is restricted, unless the
immediately without the need to repay cash until rate of discount on the bonds offers a high yield.
redemption.
The cost of redemption is known at the time of issue They are ideal for investors who are willing to
and so the borrower can plan to have funds available sacrifice periodic return for a higher return at
to redeem the bonds at maturity. maturity.
The only way of obtaining cash from the bonds

before maturity is to sell them, and their market
value will depend on the remaining term to maturity
and current market interest rates.
(iii) Convertible Bonds and Warrants (Hybrids)

A hybrid is a financial instrument that combines features of equity and debt. Convertible bonds and warrants are
examples of hybrids.
Convertible bonds are fixed interest debt securities which give the holder the right to convert the bond into
ordinary shares of the company. The conversion takes place at a pre-determined rate and on a pre-determined
date. If the conversion does not take place the bond will run its full life and be redeemed on maturity. Conversion
rates often vary overtime. Once converted, convertible securities cannot be converted back into original fixed
return security.
A warrant is similar to a convertible bond in that the warrant allows the holder to buy stock at a set price (rather
than convert the underlying bond into stock). As such the ‘stock’ part of a warrant can be separated from the bond
and traded on its own whereas a convertible bond cannot be separated.
Some Key Concepts Related to Convertible Bonds:

How they work?
Interest is paid at an agreed rate for a specified period. At the end of the period the holder can choose to be repaid in cash
or to change the debt into equity shares. Whether or not conversion occurs depends on the share price at the conversion
date. The issuing company will need to raise cash in order to pay back the amount if conversion is not chosen.
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Conversion Rate:
The conversion rate is expressed as a conversion price. i.e. the price of one ordinary share that will be appropriated from
the nominal value of the convertible bond. Conversion terms may vary over time.
Conversion Value:
The current market value of ordinary shares into which a loan note may be converted is known as the conversion value.
The conversion value will be below the value of the note at the date of issue, but will be expected to increase as the date
for the conversion approaches on the assumption that a company’s shares ought to increase in market value over time.
Conversion Premium:
A conversion premium is the difference between the market price of the convertible bond and its conversion value. In
other words, it is the difference between the market price of the convertible bond and the market price of shares into
which the bond is expected to be converted.
Conversion value = Conversion ratio x Market price/share (Ordinary shares)

Conversion premium = Current market Price – Conversion value
As the conversion date approaches the market price of a convertible bond and its conversion value tend to be equal. In
other words, the conversion premium will be negligible. Initially the conversion value is lower than the market value of the
bond. The conversion premium is proportional to the time remaining before conversion. It is highest in the beginning and
decreases so that, just before conversion, it is negligible.
Interest Rate on Convertible Debt:
Convertible securities attract lower interest rates than straightforward debt due to the presence of a conversion right. The
lender is, in effect, lending money and buying a call option on the company’s shares.
Market price of convertibles:
The actual market price of convertible notes depends upon: 1. The price of straight debt. 2. The current conversion value.
3. The length of time before conversion may take place. 4. The markets expectation as to future equity returns and the
risks associated with these returns.
Example # 02:
ABC PLC has issued a convertible bond successfully. The terms of the bond are as follows. Par value of each bond
£100 Conversion ratio 50 Conversion premium 100%.
Required:
What is ABC’s share price at issue?
Answer:
The conversion ratio is the number of shares into which each bond will convert. Thus £100 bond converts into 50
shares, giving a nominal £2 per share. The conversion premium is the premium that the £2 represents over the
share price at issue. If the £2 at conversion is 100% over the share price at issue, then price at issue must be £1.
Illustration # 01:
If the conversion ratio is 50 and the market price per share is Rs. 800, then the conversion value would be:
Conversion value = 50 x 800 = Rs. 40,000
Illustration # 02:
If the current market price is Rs. 45,000 and the conversion value is Rs. 40,000, then is the conversion premium
would be:
Conversion premium = 45,000 – 40,000 = Rs. 5,000
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Advantages and disadvantages of Convertible Bond:

A convertible bond offers the unique combination of Future dividend payments are not taken
fixed interest plus lower risk in the beginning and the into account in the calculations. Therefore,
possibility of higher gains in the long run. after conversion there may be less profit
For Investors
available for distribution as dividends. In

this case investors will incur an opportunity
cost related to their investment.
Investors get an opportunity to participate in the
growth of the company.
It is possible for investors to evaluate the
performance of a company and then decide whether
to opt for conversion.
Convertible bonds serve a company as delayed On conversion there will be a reduction in

equity. Thus a company can delay the issue of EPS.
ordinary shares (equity) and the resultant reduction
in earnings per share (EPS).
Similarly, if the directors feel that the prices of On conversion there may be a reduction in
For Company
shares of the company are depressed at present and the control of existing shareholders.
therefore do not represent a favorable time to issue
new ordinary shares immediately it may issue
convertible bonds.
The interest payable on the bond is tax deductible. Before conversion gearing will be higher,
thereby affecting the risk profile of the
company.
Since interest payments are fixed financial planning
becomes easier.
(iv) Bank Loans
Medium or Long-Term
Banks provide term loans as medium or long-term financing for customers. The customer borrows a fixed amount
and pays it back with interest. The capital is typically repaid at the end of the term although it may be repayable
in tranches. With a loan both the customer and the bank know exactly what the repayment of the loan will be and
how much interest is payable and when. This makes planning (budgeting) simpler compared with the uncertainty
of the overdraft.
Key Features:
 Lower Interest Rate
 Higher Loan Amounts
 Repayment in Instalments
 Flexibility customised as per the requirement
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Short Term Loan

A short term loan is a type of loan that is obtained to support a temporary personal or business capital need. As
it is a type of credit, it involves repaying the principle amount with interest by a given due date, which is usually
within a year from getting the loan.
A short term loan is a valuable option, especially for small businesses or start-ups that are not yet eligible for a
credit line from a bank.
Key Features:
 Easier to acquire
 Quick funding time (Short Maturity Time)
 Less Riskier
 Shorter time for incurring interest (low interest payments as compare to long term interest.)
Other Common Features of Short Term / Long Term Bank Loans:
 Interest and fees are tax deductible.

 Once the loan is taken interest is paid for the duration of the loan.
 A loan might become immediately repayable if loan covenants are breached but failing that the cash is
available for the term of the loan.
 Can be taken out in a foreign currency as a hedge of a foreign investment.
 A company can offer security in order to secure a loan.
Example # 03:
Company XYZ, a manufacturing firm, is considering financing options for expanding its operations. They are
contemplating between obtaining a short-term loan and a long-term loan.
Required:
Generally analyze which option would be more suitable for Company XYZ's expansion plans.
Answer:
Considering Company XYZ's expansion plans, they need to assess their financing needs and the nature of their
investment. If the expansion involves acquiring new machinery, expanding facilities, or investing in long-term
projects with returns realized over several years, a long-term loan would be more appropriate. Long-term loans
provide the necessary capital with manageable repayment terms, aligning with the timeline of the expansion
project and minimizing immediate financial strain.
Conversely, if the expansion involves short-term needs such as increasing inventory to meet seasonal demands or
addressing temporary cash flow gaps, a short-term loan might suffice. However, relying too heavily on short-term
financing for long-term investments can strain cash flow and increase financial risk due to higher interest rates
and the potential need for frequent refinancing.
In conclusion, the choice between short-term and long-term loans for Company XYZ's expansion should be based
on the nature of the investment, cash flow projections, and the company's overall financial strategy. It's essential
to balance the need for immediate capital with the long-term financial health and sustainability of the business.
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Difference between Bank Loan and Loan Stock:

If company wants to know which type of loan is beneficial for it either bank loan or loan stock, then it considers
the following points:
Feature Bank loans Loan stock
It may be possible to alter the terms of the
Flexibility bank loan as the finance requirements of the Terms are fixed
company changes
Customer will have to fulfil the publicity
Only the bank will require limited
Confidentiality requirements that an issue of loan stock on
information as part of the loan application
the financial markets would need
Slower to arrange due to the need to fulfil the
Speed Quick to arrange
requirements of a public issue
Costs Low cost High issuance costs
Restrictions such as collateral and possible
Restrictions Much less restrictive
restrictive covenants are normally required
Detailed financial information such as
Financial
budgets and management accounts may No such submissions required
information
have to be submitted periodically to the bank
Short Term Sources of Finance:

(i) Overdrafts
With an overdraft facility the borrower can borrow through their current account on a short-term basis up to an
agreed overdraft limit. However, overdrafts are repayable on demand whereas term loans are repayable only on
the date(s) agreed when the loan was arranged.
Other features include:

 Interest and fees are tax deductible.
 Interest is only paid when the account is overdrawn.
 Penalties for breaching overdraft limits can be severe. Overdrafts are normally used to finance day-to-day
operations and as such form an important component of working capital management policies.
(ii) Certificates of deposit (CDs)

A CD is a security that is issued by a bank, acknowledging that a certain amount of money has been deposited with
it for a certain period of time (usually, a short term). The CD is issued to the depositor, and attracts a stated
amount of interest. The depositor will be another bank or a large commercial organization.
CDs are negotiable and traded on the CD market (a money market), so if a CD holder wishes to obtain immediate
cash, he can sell the CD on the market at any time. This secondary market in CDs makes them attractive, flexible
investments for organizations with excess cash.
(iii) Treasury bills (T-bills)

Treasury bills are issued by a government to finance short-term cash deficiencies in the government's expenditure
program. They are essentially bonds issued by the government, giving a promise to pay a certain amount to their
holder on maturity. Treasury bills typically have a term of less than a year to maturity after which the holder is
paid the full value of the bill.
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(iv) Trade Credit:

Credit available from supplies is one of the easiest and cheapest sources of short term finance. If credit is obtained,
it reduces the need for finance from other sources e.g. banks.
Advantages and disadvantages

The advantage of trade credit is that no interest is Delays in payment will worsen a company’s credit
usually charged unless the firm defaults on payment. rating.
Current assets such as raw materials can be purchased
Additional credit is difficult to obtain if you are
on credit with payment terms normally varying
currently delaying the payments.
between 30 to 90 days.
Cost of trade credit beyond the agreed terms is very
In a period of high inflation, purchasing through trade
high in terms of the penalty interest charged as well
credit will be very helpful in keeping costs down.
as in terms of retaining relations with suppliers.
Leases:
An agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to
use an asset for an agreed period of time (IFRS 16).
As per IFRS 16 lessee shall capitalize all leases except short term and low value lease and IFRS 16 identifies two
types of lease for Lessor one is finance lease and other is operating lease:
Finance lease:
A finance lease is a lease that transfers substantially all the risks and rewards incidental to ownership of an asset.
Title may or may not eventually be transferred.
Operating Lease:
An operating lease is a lease other than a finance lease.
The tax deductibility of rental payments depends on the tax regime but typically they are tax deductible in one
way or another.
Finance leases are capitalized and affect key ratios (ROCE, gearing)
In both cases:
 Legal ownership of the asset remains with the lessor
 The lessee has the right of use of the asset in return for a series of rental payments.
The leases differ in the following respects for lessor:

Finance lease Operating lease
Lease term Long (compared to the life of the Short (compared to the life of the
asset). Usually for major part of the asset)
asset’s life.
Risks/Rewards of Pass to the lessee Remain with the lessor
ownership
Insurance of the asset Lessee’s responsibility Lessor’s responsibility
Maintenance of the asset Lessee’s responsibility Lessor’s responsibility
Ownership Ownership will transfer to lessee (often Ownership will not transfer to lessee.
at a low price – giving the lessee a
bargain purchase option)
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JUST FOR UNDERSTANDING OF STUDENTS

Leases can be classified into two main types: operating leases and finance leases. The classification depends on the nature
of the lease agreement and the extent to which risks and rewards associated with ownership are transferred to the lessee.
Let's discuss whether each type of lease is considered a short-term or long-term source of finance:
Operating Lease:
Short-term source of finance: Operating leases are typically considered short-term sources of finance because they are
more akin to renting an asset rather than purchasing it. These leases are usually shorter in duration, often lasting for a
term of less than the economic life of the asset. They allow the lessee to use an asset for a specific period without assuming
the risks and rewards of ownership. Short-term leases are often used for assets that have a shorter useful life or are
subject to rapid technological advancements.
Long-term source of finance: However, in certain cases, operating leases can also be considered long-term sources of
finance, especially if the lease term is substantial and covers a significant portion of the asset's economic life. Some
operating leases may extend for a significant duration, providing a stable and predictable use of the asset over the long
term.
Finance Lease:
Long-term source of finance: Finance leases are typically considered long-term sources of finance because they resemble
ownership of the leased asset. In a finance lease, the lessee assumes substantially all the risks and rewards associated
with ownership. These leases usually cover the majority of the asset's economic life, and the lessee is often responsible
for maintenance, insurance, and other ownership-like responsibilities. Finance leases are structured in a way that the
lessee effectively finances the purchase of the asset over the lease term.
Short-term source of finance: Finance leases are generally not considered short-term sources of finance because they
involve significant commitments over an extended period. However, in some cases where the lease term is relatively short
compared to the economic life of the asset, and the lessee has the option to terminate the lease early without substantial
penalties, it might be considered a short-term source of finance. However, this scenario is less common for finance leases.
Conclusion:
Operating leases are typically considered short-term sources of finance due to their rental-like nature and shorter
durations, while finance leases are generally regarded as long-term sources of finance because they resemble ownership
and involve substantial commitments over extended periods. However, the classification may vary depending on the
specific terms and duration of the lease agreement.
Advantages and disadvantages of Debt Finance:
For Investors
Investors are entitled to a fixed return each year thus Debt holders do not have any voting rights.
reducing the risk of variable income (e.g. dividends).
In the case of non-payment of interest, debt holders In case of high profit, their interest will be limited
can appoint a liquidator. (fixed interest).
Debt is attractive to investors because it will be If the bonds or debentures are unsecured, the
secured against the assets of the company. investment will be high risk compared to secure loans.
In the case of liquidation debt holders rank higher than
other payables for recovery of dues.
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For Company
Debt is a cheaper form of finance than equity because, Companies have to provide security against the debt
unlike dividends, debt interest is tax deductible in provided which may limit their use of the mortgaged
most tax regimes. asset.
Debt holders do not have any voting rights and In the case of very low profits or losses fixed interest
therefore will not participate in the decision making still has to be paid.
process therefore the current owners do not have to
yield decision making powers.
In the case of high profits companies only have to pay
In the case of non-payment of interest debt holders
a fixed interest. can appoint liquidators which will affect the
reputation of the company.
There is no immediate dilution in earnings and In the case of company liquidation, the company must
dividends per share. repay the debt holders first.
Low issuance cost as compared to equity. The future borrowing capacity of the firm will be
reduced as there will be fewer assets to provide
security for future loans.
Provides the company with a facility to raise cash. The real cost is likely to be high as compared with
other sources of finance.
The more highly geared the company, the higher will
be its risk profile.
128
LO 03: ISLAMIC FINANCE

Islamic finance includes financing activities that should comply with Sharia (Islamic Law). Certain practices and
principles under conventional financing products are strictly prohibited under Shariah, hence, the need for Islamic
financing.
Examples of prohibitions include: Riba (interest), Speculation (gambling) etc.
There two important principles on which the Islamic finance is based:

 Each transaction must be related to a real underlying economic transaction.
 The lender cannot charge Riba (interest) from the borrower. Parties entering into the contracts share
profit/loss and risks associated with the transaction. No one can benefit from the transaction more than the
other party.
(i) Murabaha:
One of the most popular modes used by banks in Islamic countries to promote riba free transactions is Murabaha.
Murabaha is a particular kind of sale where seller expressly mentions the cost he has incurred on the commodities
to be sold and sells it to another person by adding some profit or mark-up thereon which is known to the buyer.
Thus Murabaha is a cost plus transaction where the seller expressly mentions the cost of a commodity sold and
sells it to another person by adding mutually agreed profit thereon which can be either in lump-sum or through
an agreed ratio of profit to be charged over the cost, thus resulting in an absolute price.
Basic Features of Murabaha:

Description Example
1 The subject matter of sale must be existing at the time of A sells the unborn calf of his cow to B. The
sale. sale is void.
2 The subject matter of sale must be in the ownership of A sells to B a car, which is presently owned,
the seller at the time of sale, and he must have a good by C, but A is hopeful that he will buy it from
title to it. C and shall deliver it to B subsequently. The
sale is void.
3 The subject matter of sale must be in the physical or A has purchased a car from B. B has not yet
constructive possession of the seller when he sells it to delivered it to A or to his agent. A cannot sell
another person. the car to C. If he sells it before taking its
delivery rea or constructive from B the sale is
void.
4 The delivery of the sold commodity to the buyer must be A sells his car stolen by an anonymous person
certain and should not depend on a contingency or and the buyer purchases it under the hope
chance. that he will manage to recover it. The sale is
void.
5 The absolute certainty of price is a necessary condition A says to B, "if you pay within a month, the
for the validity of a sale. price is Rs.50/. But if you pay after two
months, the price is Rs.55/- B agrees without
absolutely determining one of the two prices.
In this case as the price remains uncertain the
sale is void, unless anyone of the two
alternatives is settled by the parties at the
time of concluding the transaction.
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6 The sale must be unconditional. A buys a car from B, with a condition that B
will employ his son in his firm. The sale is
conditional, hence invalid.
7 A sale is valid in which the parties fix the price and due
date of payment in an unambiguous manner. The due
time of payment can be fixed either with reference to a
NIL
particular date, or by specifying a period of time, but it
cannot be fixed with reference to a future event, the
exact date of which is unknown or is uncertain.
8 The sale must be prompt and absolute. NIL
9 The subject matter of sale must be a property of value. NIL
(ii) Ijarah:
Ijarah is a contract whereby the owner of an asset (lessor), other than consumable, transfers its usufruct to
another person (lessee) for an agreed period for an agreed consideration.
The lessor, however, retains the right of ownership of the asset and is legally bound to bear the risks of the asset,
which also includes obligations to repair any damage caused naturally or due to wear and tear, insurance,
accidental repairs for the asset. While, actual operating/overhead expenses related to running the asset, any
damage to the asset arising out of his negligence will be borne by the lessee.
The lessor cannot charge late payment penalty as his income.
Lease and Sale agreement should be separate and non-contingent.
In conventional lease the Lessor has the unilateral right to rescind the lease contract at his sole discretion,
however, in Ijarah the lease contract can be terminated with mutual consent.
(iii) Mudaraba:
Mudaraba is a partnership in profit whereby one party provides capital (Rab al maal) and the other party provides
labour (mudarib).
Mudarib may also contribute capital with the consent of the Rab al maal.
There are two types of Mudaraba:
Restrictive Mudaraba – means that the investor has specified investment details in the Mudaraba contract and
has restricted the working partner within the scope of such specifications.
Unrestrictive Mudaraba – means that the investor has granted the working partner the right to undertake any
lawful investment to make profits. It is the responsibility of the working partner to avoid unlawful and high-risk
investments. The working partner is liable for any losses suffered from such investments.
(iv) Musharaka:
Relationship established under a contract by the mutual consent of the parties for sharing of profits and losses
arising from a joint enterprise or venture.
The profit is distributed among the partners in predetermined ratios, while the loss is borne by each partner in
proportion to his contribution.
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JUST FOR UNDERSTANDING OF STUDENTS

Murabaha Financing:
Scenario: A small business owner in Pakistan wants to purchase machinery for expanding their operations
but lacks the necessary funds.
Solution: The Islamic bank could offer Murabaha financing, where the bank purchases the machinery and
sells it to the business owner at a higher price, allowing for deferred payment in installments.
Musharaka Financing:
Scenario: Two entrepreneurs in Pakistan wish to start a business together but lack sufficient capital
individually.
Solution: The Islamic bank could facilitate a Musharaka arrangement where both entrepreneurs and the
bank contribute capital to the business venture. Profits and losses are shared based on pre-agreed ratios,
ensuring a fair distribution of returns.
Ijarah Financing:
Scenario: A Pakistani individual wants to lease a car for personal use but wishes to avoid conventional
interest-based leasing.
Solution: The Islamic bank can provide Ijarah financing, where the bank purchases the car and leases it to
the individual for a fixed period, charging a rental fee. At the end of the lease term, the individual may have
the option to purchase the car at an agreed-upon price or return it.
Mudaraba Financing:
Scenario: An entrepreneur in Pakistan has a business idea but lacks the necessary expertise to execute it
effectively.
Solution: The Islamic bank could enter into a Mudaraba partnership with the entrepreneur, providing the
necessary capital while the entrepreneur contributes their expertise and manages the business operations.
Profits generated are shared based on a pre-agreed ratio, while any losses incurred are borne by the bank
as the capital provider.
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LO 04: OTHER COMMON SOURCES OF FINANCE:

Other common sources of finance include the following:
 Venture Capital
 Business Angels
 Private Equity Funds
 Asset securitization and sale
(i) Venture Capital (VC):

The term ‘venture capital’ is normally used for capital provided to a private company by specialist investment
institutions, sometimes with support from banks in the form of loans.
The company must demonstrate to the venture capitalist organization that it has a clear strategy and a convincing
business plan.
A venture capital organization will only invest if there is a clear ‘exit route’ (e.g. a listing on an exchange).
Investment is typically for 3-7 years after which the VC will realize their profits and exit the investment.
Factors to consider the appropriateness of Venture Capital:
 VC is an important source of finance for management buy-outs.
 VC can provide finance to take young private companies to the next level.
 VC may provide cash for start-ups but this is less likely.
(ii) Private Equity Funds:

Private equity describes equity in operating companies that are not publicly traded on a stock exchange. Private
equity as a source of finance includes venture capital and private equity funds.
A private equity fund looks to take a reasonably large stake in mature businesses.
In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature
company and tries to enhance value by eliminating inefficiencies or driving growth.
Their view is to realize the investment, possibly by breaking the business into smaller parts.
Private equity’s approaches to eliminate inefficiencies usually by downsizing have attracted criticism.
Factors to consider the appropriateness of private equity fund:
For example, if the company wants to judge when private equity fund is appropriate it should consider the
following points:
 If used as a source of funding a private equity fund will take a large stake (30% is typical) and appoint directors.
 Private equity is a method for a private company to raise equity finance where it is not allowed to do so from
the market.
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(iii) Business Angels:

Business angels are wealthy individuals who invest directly in small businesses, usually by purchasing new equity
shares. Angels do not get involved in the management of the company.
Business angels are not that common. There is too little business angel finance available to meet the potential
demand for equity capital from small companies. Business angels are way for small companies to raise equity
finance, normally at the very start of their life.
(iv) Asset securitization and sale:

Securitization is the process of converting existing assets or future cash flows into marketable securities.
Typically, the following occur simultaneously:
 Company A sets up Company B (described as a special purpose vehicle or SPV) and transfers an asset to it (or
rights to future cash flows).
 Company B issues securities to investors for cash. These investors are then entitled to the benefits that will
accrue from the asset.
 The cash raised by Company B is then paid to Company A.
In substance this is like Company A raising cash and using the asset as security. Accounting rules might require
Company A to consolidate Company B even though it might have no ownership interest in it.
Conversion of existing assets into marketable securities is known as asset-backed securitization and the
conversion of future cash flows into marketable securities is known as future-flows securitization.
Factors to consider the appropriateness of asset securitization and sale:
 Asset securitization is used extensively in the financial services industry.
 Securitization allows the conversion of assets which are not marketable into marketable ones.
 Securitization allows the company to borrow at rates that are commensurate with the rating of the asset. A
company with a credit rating of BB might hold an asset rated at AA. If it securitizes the asset it gains access to
AA borrowing rates.
133
Practice Set Questions

Question # 01:
Explain the key features of the sources of finance listed below. Describe when it might be appropriate to use each
of them:
(a) Equity (shares)
(b) Leases
(c) Venture capital
(d) Business angel
(e) Private equity fund
Question # 02:
(a) Distinguish between direct and indirect investment.
(b) Discuss how the liquidity and holding period for direct and indirect investment might vary.
(c) Differentiate between investment and speculation
Question # 03:
Discuss the difference between Ijarah and conventional lease.
Question # 04:
Explain types of Modarba mode of Islamic financing.
Question # 05:
Discuss the principles of sale under Morabaha mode of Islamic financing.
134
Practice Set Answers

Answer # 01:
(a) Equity (shares)

Features:
Finance raised through sale of shares to existing or new investors (existing investors often have a right to invest
first – pre-emption rights).
Providers of equity are the ultimate owner of the company. They exercise ultimate control through their voting
rights.
Issue costs can be high.
Cost of equity is higher than other forms of finance – they carry the risk, and therefore command the highest
of returns as compensation.
New issues to new investors will dilute control of existing owners.
When appropriate:
Used to provide long-term finance. May be used in preference to debt finance if company is already highly
geared. Private companies may not be allowed to offer shares for sale to the public at large (e.g. in the UK).
(b) Leases:
Features:
Two types:
 Operating leases – off balance sheet
 Finance leases – on balance sheet
Legal ownership of the asset remains with the lessor.

Lessee has the right of use of the asset in return for a series of rental payments.
Tax deductibility of rental payments depends on the tax regime but typically they are tax deductible in one way
or another.
Finance leases are capitalised and affect key ratios (ROCE, gearing).
When appropriate:
Operating leases
 For the acquisition of smaller assets but also for very expensive assets.
 Common in the airline industry
Finance leases
 Can be used for very big assets (e.g. oil field servicing vessels)
(c) Venture capital

Features:
The term ‘venture capital’ is normally used to mean capital provided to a private company by specialist
investment institutions, sometimes with support from banks in the form of loans.
The company must demonstrate to the venture capitalist organisation that it has a clear strategy and a
convincing business plan.
A venture capital organisation will only invest if there is a clear ‘exit route’ (e.g. a listing on an exchange).
Investment is typically for 3-7 years.
135
When appropriate:
An important source of finance for management buy-outs.
Can provide finance to take young private companies to the next level.
May provide cash for start-ups but this is less likely.
(d) Business Angels

Features:
Business angels are wealthy individuals who invest directly in small businesses, usually by purchasing new
equity shares, but do not get involved in the management of the company.
Business angels are not that common.
There is too little business angel finance available to meet the potential demand for equity capital from small
companies.
When appropriate:
A way for small companies to raise equity finance.
(e) Private equity funds

Features:
Private equity is equity in operating companies that are not publicly traded on a stock exchange.
Private equity as a source of finance includes venture capital and private equity funds.
A private equity fund looks to take a reasonably large stake in mature businesses.
In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature
company and tries to enhance value by eliminating inefficiencies or driving growth.
Their view is to realise the investment, possibly by breaking the business into smaller parts.
When appropriate:
If used as a source of funding a private equity fund will take a large stake (30% is typical) and appoint directors.
It is a method for a private company to raise equity finance where it is not allowed to do so from the market.
Answer # 02:
(a) Direct and indirect investment

Direct investment describes when an investor owns all or part of an asset. With indirect investment, the
investor gains exposure to the risks and rewards of an underlying asset without actually owning it through
vehicles such as securities, funds, derivatives and private equity.
Taking property as an example, a direct investor might own a building then make a profit from the capital
appreciation when they sell the building. The indirect investor might invest in an investment fund whose return
is then based on the average movement in property values. The indirect investor will make a profit as property
values grow without actually owning the building.
(b) Liquidity and holding period

Liquidity:
Liquidity of direct investments tends to be lower due to the size (larger) and uniqueness of the investment.
Indirect holdings might be more liquid than direct investments as investment funds are often open-ended with
investors entering and leaving the investment vehicle frequently in an open market.
136
Holding period:
The holding period might typically be longer-term for direct investors and may even be permanent, for example
when a company owns a factory in a foreign territory.
The holding period might be lower and more medium-term for an indirect investment for example investing in
a real estate investment fund until a price target has been met.
(c) Investment and speculation

Investment and speculation are similar in that they both involve an investor risking capital in the expectation of
making a profit. However, the following differences might be observed:
 Investment is normally long-term following a period of careful research. Speculation is typically more short-
to medium-term and may be driven by intuition, rumour, charts plus a limited amount of research.
 Investors tend to be risk neutral with an expectation of moderate returns in exchange for taking moderate
risk. Speculators are more risk seekers who expect higher returns in exchange for taking higher risk.
 Investment often involves putting money into an asset that isn’t readily marketable in the short-term but has
an expectation of yielding a series of returns over the life of the investment. The investment return would
normally arise from both capital appreciation and yield (interest, dividends and coupons).
 On the other hand, speculators often invest in more marketable assets as they do not plan to own them for
too long. Speculation returns would typically arise purely from capital (price) appreciation rather than yield.
 Investment normally includes an expectation of a certain price movement or income stream whereas
speculators will normally expect some kind of change without necessarily knowing what.
Answer # 03:
The differences between Ijarah and Conventional Lease are as follows:
Ijarah Conventional Lease

Ownership The lessor retains the right of ownership. The lessor transfers the right of ownership of
the asset to the lessee.
Risk The lessor is legally bound to bear the risks of The lessor transfers the risks related to the
the asset. Any loss or harm caused by factors asset to the lessee.
beyond the control of the lessee shall be
borne by the lessor.
Sale and Sale and lease back are allowed, but only as This transaction involves the sale of the asset
Leaseback two separate transactions. by one party to another which in turn leases
the same property back to the original seller.
Penalty The lessor cannot charge late payment Penalty charged to the lessee for delayed
penalty as his income. payment is only to be used for charitable
purposes by the lessor.
137
Answer # 04:
There are two types of Mudaraba,
(i) Restrictive Mudaraba:

Restrictive Mudaraba means that the investor has specified investment details in the Mudaraba contract and has
restricted the working partner within the scope of such specifications.
(ii) Unrestrictive Mudaraba:

Unrestrictive Mudarabas mean that the investor has granted the working partner the right to undertake any lawful
investment to make profits. It is the responsibility of the working partner to avoid unlawful and high risk
investments. The working partner is liable for any losses suffered from such investments.
Answer # 05:
Principles regarding sale under Murabaha mode of Islamic financing are as follows:
(i) The subject matter of sale must be existing at the time of sale.
(ii) The subject matter of sale must be in the ownership of the seller at the time of sale, and he must have
a good title to it.
(iii) The subject matter of sale must be in the physical or constructive possession of the seller when he sells
it to another person.
(iv) The sale must be prompt and absolute.
(v) The subject matter of sale must be a property of value.
(vi) The delivery of the sold commodity to the buyer must be certain and should not depend on a chance
or contingency.
(vii) The absolute certainty of price is a necessary condition for the validity of a sale.
(viii) The sale must be unconditional.
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Past Paper Questions

Question # 01:
Agha Limited (AL), a family owned business, is considering expanding its operations. The expansion would
require the finance amounting Rs. 50 million. Agha Junaid, CEO, has proposed to finance the expansion through
a bank loan as he believes that financing through equity shares outside the family would mean sharing the
decision making power in the board meetings and AL is not ready to compromise on that. Fauzia Agha, Finance
Director, mentioned that AL’s bank is offering loan on strict terms and conditions thereby increasing the future
compliances. She has proposed that AL should finance through issue of equity shares. She believes that new
shareholders would only have stake of 10% in shareholdings of AL and therefore, have barely any say in decision
making.
Required:
(a) Evaluate the proposals of CEO and Finance Director.
(b) Recommend how AL may finance the expansion.
{ICAP Model Paper, Q # 06, 08 Marks}
Question # 02:
4 Clients of Arsal Limited need financial advisory:
Satrangi Limited:
The company is facing difficulty in managing its working capital. The company needs to finance its raw material
stock in specific as the suppliers do not extend a longer credit period
Khaadi Limited:
Khaadi Limited is considering to invest in a project which would extend over period of three year. The company
will get interim cash flows every year from the project.
Bonanza Limited:
BL need finance to form a pharma company in UK. The company will conduct detailed research comprising
almost 4 years before going to production phase. Expected cash flows will accrue after 6 to 7 years of
investment production
Gull Ahmed Limited:

GL is considering to bid for a sea shore cleaning contract from government where the government will pay the
entire amount to the company once the three year contract is complete. No interim cash flows will be available
from the project.
Required
You are the chief advisor of the firm you have to suggest the best source of finance from following operations
(a) Equity with a cost of equity of 16%.

(b) Long term bank Loan where interest is paid lump sum at the end of 4 years.
(c) Long term bank Loan where interest along with a part of principal over a period of 3 years.
(d) A Bank OD/Short term running finance.
{Exam Standard Question}
139
Question # 03:
Ansari & Co. Chartered Accountants are providing financial consultancy to Dolce Limited and Gabbana Limited:
Dolce Limited
DL Company was established 50 years ago and was one of the most successful companies of the industry.
However past five years have been a very challenging due to bad governance add leaving of key employees. The
company currently is in the process of a management change which is positively affecting the profits of the
company. The share price is at the lowest of past eight years but the company's new management is optimistic
that a turnaround will occur in next three to four years. Company needs finance for a four year project which
would provide small interim cash flows but will eventually result in substantial profits in last year of the project.
Annual Cash flows of the company are not enough to pay commercial interest rate on a loan from the bank
(current incremental borrowing rate for the company is 18%). Maximum interest the company can pay is 10%.
Gabbana Limited
The company is s in business for the last six years iron enjoys substantial growth. The company is considering to
invest in a project having a life of five years. Cash flows from the project from initial three years will not be
substantial enough to pay the interest of the loan, hence, the company will need to use operational cash flows
to pay interest. The company is confident that it will be able to generate enough operational cash flows during
the first three years of the project to pay off the interest.
In the fourth year of the project a substantial amount of cash will inflow to the company. The off Pa bank loan in
fourth year. However the bank charges a penalty of 12% on early repayment. The company the listed company.
Required:
Advise both the companies with best possible source of finance and elaborate the key features of companies
finance and how will that help the company.
Question # 04:
Stabba is a company that is being converted from private to public company status and is planning a stock
market flotation with a public offer of shares. In the flotation, the company wants to raise Rs.800 million in cash
for investment in its businesses. Issue costs will be 5% of the total amount of capital raised. The company’s
investment bank advisers have suggested that a share price of Rs.800 to Rs.900 per share should be sustainable
after the flotation, and a suitable issue price per share would therefore be Rs.800.
Required:
How many new shares should be issued and sold in the public offer?
Question # 05:
Abid Foods Limited (AFL) has issued 8,000 convertible bonds of Rs. 100 each at par value. The bonds carry
markup at the rate of 8% which is payable annually. Each bond may be converted into 10 ordinary shares of AFL
in three years. Any bonds not converted will be redeemed at Rs. 115 per bond.
Required:
Calculate the current market price of the bonds, if the bondholders require a return of 10% and the expected
value of AFL’s ordinary shares on the conversion day is:
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(a) Rs. 12 per share

(b) Rs. 10 per share.
{Autumn-16, Q # 09, 06 Marks}
Question # 06:
Discuss any three advantages and three disadvantages if a project is financed through debt as against when it is
financed through equity.
{Autumn-18, Q # 05(a), 03 Marks}
Question # 07:
For the purpose of this question, assume that today is 01 March 2020.
On 01 March 2018, Shahab Pakistan Limited (SPL) purchased 10,000 convertible bonds of Delphi Limited (DL) at
par value of Rs. 100 each. The bonds carry annual mark-up of 12% which is payable semi-annually that is at the
end of February and August each year. Each bond is convertible into 5 ordinary shares of DL which are currently
trading at Rs. 24 each. Any bonds not converted by 28 February 2022 will be redeemed at Rs. 120 per bond.
SPL’s cost of capital is 15%.
Required:
Advise whether SPL should hold the bonds till redemption or convert them into ordinary shares today. Also
determine at what market price per share SPL would be indifferent to hold bonds till redemption or convert into
shares today. (Ignore tax)
{Spring-20, Q # 06, 04 Marks}
Question # 08:
Discuss any four factors that a company may need to consider before deciding on whether to finance the
expansion by issuing new shares or convertible bonds.
{Autumn-22, Q # 09(c), 04 Marks}
141
Past Paper Answers

Answer # 01:
Agha Junaid (CEO) Proposal:
Junaid's proposal centers on retaining control within the family business by avoiding the issuance of equity shares
to external stakeholders. Taking on debt, in the form of a bank loan, will indeed allow the family to maintain its
ownership and control. However, there are several issues with this approach:
1. Increased Financial Risk: Borrowing increases a firm's financial risk as the company must meet its repayment
obligations regardless of its profitability. If the expansion doesn't generate the expected return, AL might have
difficulty repaying the loan.
2. Interest Costs: Borrowing money requires paying interest, which can erode profits.
3. Strict Terms and Conditions: As Fauzia mentioned, the bank is offering the loan under strict terms and
conditions. This could mean a high interest rate, restrictive covenants, or demanding repayment terms.
Fauzia Agha (Finance Director) Proposal:

Fauzia proposes to issue equity shares to finance the expansion. This plan has its advantages and disadvantages:
1. No Obligation to Repay: Unlike a loan, equity financing does not have to be repaid. This can be particularly
beneficial if the company encounters financial difficulties or if the expansion plans do not provide the expected
returns.
2. No Interest Costs: Equity financing does not incur interest costs, leaving more of the company's future earnings
available to invest back into the business.
3. Dilution of Ownership and Control: Issuing equity shares will dilute the family's ownership. Even though the
new shareholders would only have a 10% stake, they might still have some influence in decision-making,
especially if they are institutional investors with significant financial knowledge and resources.
Recommendation:
The optimal source of financing will depend on AL's specific circumstances. Here are some considerations:
1. Balanced Approach: A combination of both debt and equity could be considered. This would dilute ownership
less than a full equity issue and reduce the financial risk compared to full debt financing.
2. Alternative Debt Financing: If the terms of the current bank loan are too onerous, AL could consider other debt
financing options. This might include a loan from a different bank, or issuing bonds.
3. Non-Traditional Equity Financing: If AL decides to go for equity financing, it can consider strategic investors
who are less likely to interfere in operations or day-to-day management. This could include private equity
investors.
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Answer # 02:
Satrangi Limited:
The company needs finance for current assets (working capital). The source of finance should be overdraft.
Khaadi Limited:
The company needs finance for a long term project. Since the project is capable of generating interim cash flows
the company should use debt finance in which along with a part of principal is repaid every year.
Bonanza Limited:
The company needs finance for a long term project. Since there would not be any interim cash flows for a very
long term and cash flows beyond that long period are also uncertain and depend on the results of the research,
the company should / can only use equity source of finance.
Gull Ahmed Limited

The company needs finance for a long term project. Since there will not be any interim cash flows till the end of
the project (there years), the company can only choose between equity and deferred interest loan arrangements.
Furthermore, the amount for government is guaranteed the company should use deferred interest loan
arrangement considering its lower cost as compared to equity.
Answer # 03:
Dolce Limited
Since the share price of the company is currently very low but is expected to increase substantially over the next
few years the company should avoid issuance of equity because the company will have to issue a huge number of
shares to finance the project. The current condition of the company is also not good and issuance of equity might
result in under subscription. Furthermore, the company cannot obtain a bank loan or issue commercial debt
including loan stocks/Debenture, since the is not in position to pay off the expected interest exhausting all the
sources of cash flows expected to accrue to the company in next few years
The best possible option available to the company is the issuance of convertible bonds which will have the
following benefits to the company considering the current situation:
(i) The company will be paying a substantially lower interest rate over the life of the bond as compared
to commercial market interest rate which is not absorbable by the company.
(ii) At maturity, if the company's position becomes good, the share prices would be reasonable enough
for the holders of the bond to convert the instrument into equity shares. The company will be able to
avoid the cash outflows on redemption.
(iii) If the share prices increase over time and conversion becomes more lucrative the company will have
to issue new shares which will dilute the power and % holding of the existing shareholders.
143
The best possible solution considering the above factors will be to issue convertible bonds to avoid payment of
substantial interest initially and then payment on account of redemption at the however, the only disadvantage
is the dilution of power for the existing shareholders end
Gabbana Limited
The company is in business for the last six years iron enjoys substantial growth. The company is considering to
invest in a project having a life of five years. Cash flows from the project from initial three years will not be
substantial enough to pay the confident that it will be able to generate enough operational cash flows during the
first three years of the project to pay off the interest.
In the fourth year of the project a substantial amount of cash will inflow to the company. The company will be in
a position to pay off the bank loan in fourth year. However the bank charges a penalty of 12% on early repayment.
The company the listed company and has enough security to issue a loan stock
The company should opt for debt finance. Considering the expected huge inflow in the fourth year the company
would like to pay off the debt then.
Since long term bank loans will result in substantial (12%) penalty on early repayment, the company should issue
secured debentures. This will result in the following benefits to the company:
(i) The company will not need to follow several covenants as are present in bank loans.
(ii) The company can buy back its debentures in fourth year at a small premium which is not possible
with bank loan on account of heavy early repayment penalties.
(iii) The company will not have to provide a huge amount of security for issuing debentures as compared
to a bank loan.
(iv) The company will have to follow several legal formalities at the inception which is only deterrent in
issuing secured debentures.
The company should issue loan stock/ secured debentures to obtain the requisite finance and should buy back
them in 4th year to avoid early repayment penalties as compared to a bank loan
Answer # 04:
Cash required after issue costs (95% of cash raised) = Rs.800 million
Capital required before issue costs deducted =Rs.800 million/0.95
= Rs.842.1 million
Number of shares to issue to raise Rs.842.1 million = Rs.842.1m/Rs.800
= 10,526,250 shares
144
Answer # 05:
(a) Current market value for 8,000 convertible bonds:
Current market value for 8,000 bonds,
Cash flows for Discount
when price per share is
Year Description 8,000 bonds factor @ 10%
(a) Rs. 12 (b) Rs. 10
Rupees --------- Rupees ---------
1 (8,000×100×8%) 64,000 0.909 58,176 58,176
Interest
Annual
2 (8,000×100×8%) 64,000 0.826 52,864 52,864

3 (8,000×100×8%) 64,000 0.751 48,064 48,064
159,104 159,104
(b) Bonds’ value at higher of shares' expected value and bonds' redemption value:
Expected Redemption
value of 10 value of one
shares bond
960,000
3 (a) 120.00 115.00 0.751 720,960
(8,000 × 120)
920,000
3 (b) 100.00 115.00 0.751 690,920
(8,000 × 115)
Current market value for 8,000 convertible bonds 880,064 850,024
Answer # 06:
(i) Debt is a cheaper source of finance than (i) Company has to provide security against the
equity because, unlike dividends, cost of debt debt.
attracts tax savings.
(ii) Debt holders do not have any voting rights and (ii) Even when there are losses or very low profits,
therefore are not able to participate in the fixed interest still has to be paid.
decision making process.
(iii) Despite high profits, company only has to pay (iii) In the case of non-payment of interest, the
a fixed interest. company may be placed on the defaulters list
(iv) Low issuance cost as compared to equity. which may seriously affect the reputation of
the company.
Answer # 07:
1−(1 + 𝑖)−𝑛 1−(1 + 0.075)−4
P=R[ 𝑖
] = 60,000 [ 0.075
] 200,960
P = S (1 + i)−n = 1,200,000 (1 + 0.15)−2 907,200
1,108,160
Market value of shares if converted today (10,000×5×24) 1,200,000
SL should convert the bonds today as it gives higher value than holding till redemption.
The market price per share at which SL would be indifferent [1,108,160/50,000] 22.16
145
Answer # 08:
Following are four factors that a company may need to consider before deciding on whether to finance the
expansion by issuing new shares or convertible bonds:
Cost of Capital:
The Company must consider the cost of each financing method. Issuing shares might not incur any interest costs
but can dilute earnings per share, while convertible bonds require interest payments but offer the possibility of
conversion to equity in the future.
Dilution of Ownership:
If the company is concerned about maintaining control, they may prefer convertible bonds. While these can
potentially convert to equity, they initially allow the company to avoid the immediate dilution of ownership that
comes with issuing new shares.
Market Conditions:
If the equity market is bullish, it might be more advantageous to issue new shares as investors may be more willing
to invest, potentially at a premium. Conversely, in a bearish market, issuing convertible bonds might be more
attractive.
Financial Flexibility:
Convertible bonds offer more financial flexibility as they provide an immediate influx of cash while giving the
company the option to convert them into equity later. This can be useful if the company's financial situation or
market conditions change.
146
Multiple Choice Questions (MCQs)

1. Identify which of the following statement is not correct:
(a) Dividend rate for preference shares becomes higher in a good year and lower in a bad year
(b) Preference shareholders receive the dividend before ordinary shareholders
(c) Preference shareholders receive no right to vote on company decision
(d) Ordinary shareholders become last to be repaid in a liquidation
2. Process of offering shares first time to general public, private institutions, and public institution is called:
(a) Private placement (b) Introduction

(c) Right issue (d) Initial public offering
3. Which of the following statement is related to private placement:
(a) Co shares are already trading (at least 25% shares are held by the public) Now the company wants the
shares to be listed on a big exchange
(b) Shares are sold to one larger institutions through a broker. Not open to general public.
(c) Capitalization of profit instead of paying it through cash
(d) None of the above
4. Which of the following difference between introduction and private placement is not correct:
(a) Private placement is not cheaper than introduction

(b) Private placement will result in a smaller investor base than introduction
(c) Introduction is not quicker than private placement
(d) Private placement is with less disclosure of information than introduction
5. Which of the following is not long term debt:
(a) Euro bonds (b) Commercial papers

(c) Certificate of deposit (d) Warrants
6. Which of the following statement is not correct about bank overdraft:
(a) Repayable on demand of bank and can also be repaid immediately by the borrower
(b) Interest is not tax deductible
(c) Interest is payable only on overdrawn amount
(d) It is also called call finance
7. Which of the following statement is not wrong about certificate of deposit
(a) Its maturity is more than 1 year (b) Not tradable in money market
(c) Lenders are general public (d) None of the above
147
8. Which of the followings are generally issued in deep discount mode:
(a) Treasury bills (b) Commercial paper

(c) All of the above (d) None of the above
9. The cheapest source of finance is known as:
(a) Trade creditors (b) Treasury bills

(c) Bonds (d) Short term bank loan
10. Which of the following statement is wrong related to bonds:
(a) Bonds are issued by corporates and government

(b) It is tradable in capital market
(c) Maturity ranges from 3 to 5 years
(d) Interest coupon is paid either at annual or semiannual frequency
11. Which of the following is not the characteristic of commercial paper:
(a) Issued in deep discount mode

(b) Maturity ranges from 3 years to 25 years
(c) Issued by corporates and banks
(d) Tradable in money and capital market
12. An Euro dollar bond could be issued anywhere outside the:
(a) Pakistan (b) India

(c) China (d) None of the above
13. Long term coupon based bonds that are convertible into fixed number of shares are called:
(a) Non-convertible bonds (b) Redeemable debt

(c) Convertible bonds (d) Both B and C
14. In convertible bonds, conversion is at the option of:
(a) Holder of the bond (b) Issuer of the bond

(c) Compulsory conversion (d) All of the above
15. Which of the following difference between loan notes and bank loan is not correct:
(a) Loan note is quick to arrange than bank loan

(b) Issue cost for loan note is high than bank loan
(c) Terms are fixed in loan note and flexible in bank loan
(d) Lot of information an entity has to disclose for loan note and limited information for bank loan
148
16. Identify which of the following is not the characteristic of deep discount.
(a) Matures at discount (b) Sometimes it pays interim interest at very low rate
(c) Main return is the capital gain on redemption (d) None of the above
17. Where the ownership of asset if transferred to lessee at the end of lease. The lease is known as:
(a) Financial lease (b) Operating lease

(c) Capital lease (d) Both A and C
18. Arsal runs a chain of retail outlets of electronic items (items). Due to economic downturn, the demand
for items has declined significantly. Arsal is considering to sell the items on credit to customers but he
wants to charge some additional profit for allowing the customers to pay later. He is seeking the Islamic
mode of financing for these transactions. Which of the following modes of financing would be most
appropriate?
(a) Mudaraba, however, Arsal would need to expressly mention the retail price of the items and the
additional profit he would charge.
(b) Murabaha, however, Arsal would need to expressly mention the cost of items and the additional
profit he would charge.
(c) Musharaka, however, Arsal would need to mutually agree the profit over the cost with the customers.
(d) Credit transactions cannot be financed through Islamic mode of financing as Arsal wants to charge
profit over the retail price.
19. Danish Ibrahim is considering a start-up business. He has performed the feasibility of business and is very
optimistic about its future prospects. The business would require the investment of Rs. 5 million for
financing capital assets and working capital. Danish has Rs. 2 million as savings and looking for Islamic
mode of financing for the remaining amount. He does not want any interference from finance provider in
making business decisions. Danish should opt for:
(a) Murabaha (b) Ijarah

(c) Mudaraba (d) None of the above
20. Agha (Private) Limited (APL), a family-owned business, registered as a private company two years ago.
The business has grown exponentially and now Salman, CEO, is considering to expand the business by
introducing a new product. He has developed a comprehensive business plan and is looking for source of
finance for expansion. Salman is not sure regarding the tenure for which finance would be needed as it is
highly dependent on how product would perform in the initial years. Salman has approached a venture
capitalist to finance the expansion of business. The venture capitalist would:
(a) Likely finance the project as APL has excelled in the past two years
(b) Likely finance the project as APL has a comprehensive business plan
(c) Less likely finance the project as there is no clear exit route for venture capitalist.
(d) Less likely finance the project as it has only been 2 years since APL has registered as private company
149
Multiple Choice Questions (MCQs) Solution

01. (a) Dividend rate for preference shares becomes higher in a good year and lower in a bad
year.
02. (d) Initial public offering
03. (b) Shares are sold to one larger institutions through a broker. Not open to general public.
04. (a) Private placement is not cheaper than introduction.
05. (c) Certificate of deposit
06. (b) Interest is not tax deductible
07. (d) None of the above
08. (c) All of the above
09. (a) Trade creditors
10. (c) Maturity ranges from 3 to 5 years
11. (b) Maturity ranges from 3 years to 25 years
12. (d) None of the above
13. (c) Convertible bonds
14. (d) All of the above
15. (a) Loan note is quick to arrange than bank loan
16. (a) Matures at discount
17. (d) Both A and C
18. (b) Murabaha, however, Arsal would need to expressly mention the cost of items and the
additional profit he would charge.
19. (b) Ijarah
20. (c) Less likely finance the project as there is no clear exit route for venture capitalist.
150

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Sources of Finance

CORE SOURCES OF FINANCE

 A suitable balance between short-term and long-term funding.

 Adequate working capital.

Factors considered before selecting source of finance:

There are two main sources of finance:

Equity shareholders gain a return on their investment in two ways:

Comparison of ordinary shares and preference shares

Feature Ordinary shares Preference shares

Five principal methods for a company to raise equity finance:

(i) Initial public offer (IPO):

(ii) Private placing:

Where 25% shares are not held with the public:

(i) Right Issue:

(ii) Bonus Issue

Difference between Right Issue and Bonus Issue:

Advantages and disadvantages of Equity Sources of Finance:

Credit issues gone: Loss of control:

Learn and gain from partners: Potential conflict:

Long Term Short Term

Long Term Sources of Finance:

(i) Euro Bonds:

 A Eurodollar bond could be issued anywhere outside the USA.

 A European bond could be issued anywhere outside Japan.

 A Euro sterling bond could be issued anywhere outside the UK.

 Debenture – unsecured long-term loan

 Bond – secured long-term loan (typically between 5 and 20 years)

Some Key Concepts Related to Loan Stock:

Example # 01: (ICAP Example # 01)

Advantages disadvantages of Deep discounted bonds and Zero coupon bonds:

The only way of obtaining cash from the bonds

(iii) Convertible Bonds and Warrants (Hybrids)

Some Key Concepts Related to Convertible Bonds:

Conversion value = Conversion ratio x Market price/share (Ordinary shares)

Advantages and disadvantages of Convertible Bond:

available for distribution as dividends. In

Convertible bonds serve a company as delayed On conversion there will be a reduction in

(iv) Bank Loans

Short Term Loan

Other Common Features of Short Term / Long Term Bank Loans:

 Interest and fees are tax deductible.

Difference between Bank Loan and Loan Stock:

Short Term Sources of Finance:

Other features include:

(ii) Certificates of deposit (CDs)

(iii) Treasury bills (T-bills)

(iv) Trade Credit:

Advantages and disadvantages

The leases differ in the following respects for lessor:

JUST FOR UNDERSTANDING OF STUDENTS

Advantages and disadvantages of Debt Finance:

LO 03: ISLAMIC FINANCE

Examples of prohibitions include: Riba (interest), Speculation (gambling) etc.

There two important principles on which the Islamic finance is based:

Basic Features of Murabaha:

The lessor cannot charge late payment penalty as his income.

Lease and Sale agreement should be separate and non-contingent.

There are two types of Mudaraba:

JUST FOR UNDERSTANDING OF STUDENTS