Sources of Finance

3.1 IB Business
Learning Goals
Role of Finance for a busines

- Capital vs Revenue Expenditures

Internal Sources of Finance

External Sources of Finance

Short, Medium & Long Term Finance

Situations - what source to choose

Group 1 - Cite all the possible
expenses Jeremy faced in 2018 when
running 5 rental properties.

Group 2 - cite the possible expenses

faced by On The Green in 2018

Classify these expenses according to

capital expenditures & revenue
expenditures
 Capital Expenditures Revenue Expenditures
● Spent on fixed assets ● Payments for the regular
● Long term function running of the business
● Not intended for resale ● Wages, raw materials, rent,
● Use medium to long term electricity
finance to pay for them ● Indirect costs: insurance,
● Can provide collateral for advertising
securing additional loan
capital
 Capital Revenue
Expenditures Expenditures

OK Groups -
what did you get
for capital
expenditures?
 Capital Revenue
Expenditures Expenditures

- New cement patio

- New fence
- Roof repair

(past years - flooring,

shed)
- Upgrade to the
video projectors
- Addition of new
sand to the courts
- Purchase of kitchen
equipment
 Capital Revenue
Expenditures Expenditures

- New cement patio - Property tax

- New fence - Home
- Roof repair protection plan
- Insurance
(past years - flooring, - Mortgage (interest
shed) on loan)
- Upgrade to the - Labour
video projectors - Utilities
- Addition of new - Advertising
sand to the courts - Insurance
- Purchase of kitchen - Legal fees
equipment - Accounting fees
- Cleaning supplies
Debt vs Equity Finance
Amelia plans to start a business with $10,000 of her personal funds. According to
the fundamental accounting equation her starting position is

A - L = OE
10,000 - 0 = 10,000
After examining the needs of the business, she realizes she needs another $5000
to have enough equipment, inventory and other assets to begin operations

However, she does not know if she should use DEBT or EQUITY financing to pay
for the additional $5000 of ASSETS
Option 1 - Debt Financing - borrow $5000
If she BORROWS MONEY from a bank or other sources, it would be an example
of DEBT FINANCING. She would have $5000 more cash, but would owe $5000 too

A - L = OE
[10,000 + 5,000] - [0 + 5,000] = 10,000 .
15,000 - 5,000 = 10,000
Debt financing allows her access to $ to purchase the assets and maintain 100%
ownership of the business, however the $5000 loan is subject to interest expense,
Option 2 - Equity Finance - find an investor
Amelia may elect to avoid loans, and rather find an investor. Her aunt likes the
idea and agrees to purchase a portion of the company for $5000 cash.

A - L = OE
[10,000 + 5,000} - 0 = [10,000 + 5,000]
15,000 - 0 = 15,000
This injection of equity makes the business more valuable, however Amelia no
longer lays claim to 100% of the profits or the assets accrued by the business
Clearly there is a trade-offs of risks, and the appropriate
balance varies from one circumstance to the next
Internal and External Sources
Internal Source External Sources (Long/Short Term, Debt/Equity)
● Personal Funds ● Share capital (L.T. / E)
● Retained Profits ● Loan Capital (L.T.&S.T. /D)
● Sale of Assets ● Overdraft (S.T. / D)
● Trade Credit (S.T. / D) Venture
● Grants (L.T. & S.T. / E) Capital
● Subsidies (L.T. / E) is not in the
● Debt Factoring (L.T. & S.T.) book but
● Leasing (S.T. / D) can be a
great source
● Crowd Funding (E) of equity
● Microfinance Providers (D) finance too!
● Business Angels (L.T. / E)
Internal Sources of Finance
1. Personal Funds
2. Retained Profits
3. Sale of Assets
Organic sources of finance are a means of raising resources from within the business organization. These internal sources of finance can be
from the sale of goods and services obtained through the production process, thereby raising the required liquidity. Raising finance through this
approach is the objective of the business enterprise and has the greatest advantage of all, realizing profits through the production process, which
could lead to expansion prospects and natural growth.

However, when this Retained Earnings or Profit is reverted into the business organization, it inevitably will mean that shareholders will not receive
the dividends, which equates to their share of profits being reinvested. Therefore, potential stakeholder conflict may arise where the strategic
planning and decisions of management may clash with the aforementioned shareholders.
Firms may also reduce their capital investment by lowering their purchase of raw materials and operating on a tighter budget in order to raise or
preserve the needed capital. These restructuring and efficiency programs include, for example the adoption of lean production methods and other
cost saving approaches. The sale of assets within the organization itself would mean that the very resources needed to created productive output
would no longer be available. Nevertheless, this is sometimes an option that some business’ are faced with as a last resort.

In order to cut costs, personnel, also considered assets, are generally the first to be released since the payroll expense is usually the highest cost factor
in the business operations. Therefore the disadvantage of selling or releasing assets also referred to as the going concern or reducing your productive
capacity is linked to the fact that you need the assets to conduct business. Personnel are also difficult to replace and train since they make up the very
core of the business itself. However, firms are in the practice of selling unprofitable units such as subsidiaries, and declaring redundancies in order to
reduce losses and raise the needed liquidity during credit squeezes. If enough resources can be raised through the generation of sales revenue, this
always is the healthiest business option.
Share Capital (Equity)
Long-term inorganic sources of finance are also available to the business organization. Private as well as publicly listed
corporations both have the ability to raise funds by issuing shares or stocks of their business. Share issuing corporations,
however, do not have the privilege of controlling share ownership once shares have been issued to individuals, business’ or
other corporations. The greatest disadvantage of this source of finance is the loss of ownership and control.

Video: Lululemon IPO, Hostile Takeovers Lulu Chart Dow Chart

Once publicly listed corporations issues shares, they no longer can retract ownership therefore they effectively given away a
portion of the business. Nevertheless, this source of finance is virtually limitless, subject only to the faith and willingness
the public to provide the finance in anticipation of gains. Take exceptional note however, that the publicly listed
corporations, having gone through an extremely difficult and expensive qualification process, operate under strict guidelines
and regulations.

The qualification requirement and cost of an Initial Public Offering (I.P.O) is a distinct disadvantage that may indeed
outweigh the need to raise resources from the general public. Private corporations are also guided by regulations that allow
them to seek finance from select members of the public. Although less restrictive and arduous, the private corporations
must also comply with certain conditions which vary from country to country. Nevertheless, once again the private
corporation would also be relinquishing some control and ownership. For the smaller business’ Venture Capitalists and
Business Angels also serve as a viable source of inorganic finance.
Share Capital (Equity)
Who would you feel Who would you NOT feel
comfortable lending comfortable lending
money to? Why? money to? Why
Loan Capital - Debt Finance
Loans instruments can be either short-term, long term, overnight, or among others,
in the form of an account overdraft protection policy.

The primary disadvantage associated with these debt instruments, is that they carry a
repayment burden in the form of interest. Short-and long term loans can be negotiated with
the creditors, i.e. banks and other lending institutions in order for the business organization
to ensure a competitive rate of interest. Generally, however, the shorter the loan period, the
higher the rate of interest that the lending institution would charge.

Payday Loans - Yikes! Mortgage Calculator Business Development loans

An Indian man asks for a loan……

 Debentures (Corporate Bonds)
Debt Finance

Corporations also raise finances through the issuance of debt instruments known as
Bonds. These are effectively debentures, which require payment of interest either
during the period of issuance or at maturity, when the bond period expires. Bonds
are transferable meaning they may be issued to other individual bondholders or
investors.

Only limited corporations have the right to raise funds through the issue of
Bonds or Shares. Smaller businesses and individuals generally have the option of
long term loans or loans issued for the purchase of real estate, known as Mortgages.
A mortgage is therefore usually issued with the pledge of a specific asset.
 This form of debt
financing remains
popular through 2023
 Debentures (Corporate Bonds) - Debt Finance
US Debt Clock
Debentures are the traditional name that financial experts use to refer to loan agreements
where the debtor is a company and no security or collateral is has been placed.
Collateral is an asset that is placed in the hands of the loan giver as security or surety, which
serves to guarantee the loan. The debenture is therefore a non-securitized loan. Creditors
are interested in their Return on Investment, in the form of interest payments, and Return of
Investment (ROI), the principal amount loaned.

In order to ensure that the ROI is certain with debentures,

debtors therefore rely more on creditworthiness, which is
based on a history of payments and a certain degree of good faith
or trust. Bonds can be issues by companies or any level of Consider the municipality of
government. Here are the ratings by country. The Lasalle and the following: Capital
budgets, operating budgets,
ratings agencies tell consumers how confident they can be in a debentures, balance sheets
 Overdraft - Debt Finance
Overdraft protection is another form of finance which
simply refers to the business organization being allowed
to overdraw on its banking account payments, with
the security of knowing that the banking institution will
meet the payment obligations up to an agreed amount.

A clear advantage is the ease of access to finance coupled

with the ability of allowing the business organization to
continue engaging in its productive process
uninterrupted. In other words whenever the business
organization needs the additional finance it does not
need to continually fill-out forms or await approval from
the lending organization.

A major disadvantage is the lender can request the

repayments on demand, and there are often fees
associated with overdrafts.
Trade Credit - Debt Finance
This source allows a business to buy now and
pay later. The seller or credit provider does
not receive any cash until a later date.

The organization that sells the good/service is

called the creditor and the
organization/individual that makes the
purchase is called the debtor.

Credit cards are similar to trade credit except

that the creditor is not the business - it's the
financial institution (ex. bank) that offers the
transfer of funds through providers such as
Visa or Mastercard.
 ***Don’t worry about the math here - just follow the
Trade Credit logic when considering the tradeoff of risks***

A story of 3 wholesalers with different credit terms

“The Restaurant Brokers' study, the only one to make a distinction between chain and independent
restaurants, concluded that up to 90 percent of independent establishments close during the first year,
and the remaining restaurants will have an average five-year life span.”

Credit Terms Number of Lets

a
Clients odds ssume a
closi of them c random
ng in lo re
Wholesaler A Cash Only 252 a giv sing in a staurant
en m l
onth given ye asts 3 ye
Wholesaler B 30 Days 288 is 1 / ar is a
36 ⅓. T rs, then
he o t
Wholesaler C 90 Days 360 dds he
of t h
em

All three sell wholesale produce to restaurants,

cafeterias, nursing homes and hotels across the city.
 Lets
a
odds ssume a
Trade Credit closi of them c random
n g in lo re
a giv sing in a staurant
A story of 3 wholesalers with different credit terms en m
i s 1 /3 a
la
onth given ye sts 3 ye
r is ⅓ ars
6 . Th , then th
e od
ds o e
f t he
“The Restaurant Brokers' study, the only one to make a distinction between chain and independent m
restaurants, concluded that up to 90 percent of independent establishments close during the first year,
Offering longer credit terms might help Wholesaler C attract more
and the remaining restaurants will have an average five-year life span.”
clients, however they are far more exposed to bad debts (A/R
Creditthat will never
Terms payofthe full
Number # ofamount!)
clients likely to # of current clients likely
Clients close in the next to default
month
Some firms may offer discounts (2%) if paid within 30 days or
Wholesaler
add Aon interest
Cash Only 252
for late payments, 7
thereby 0
collecting sooners and
Wholesaler B 30 Daysbeing less
288exposed to8risky A/R 24 (for 1 month of bills)

Wholesaler C 90 Days 360 10 30 (for 3 months of bills!)

All three sell wholesale produce to restaurants,

cafeterias, nursing homes and hotels across the city.
Credit Card
Calculator

History of
Credit Cards

Delaware and
 Grants - Equity Finance
Grants are financial gifts from the government to support
business activity. They are typically one-time payments,
and do not need to be repaid. They can be given to help
small businesses or to help stimulate economic activity in a
certain area.

I would recommend applying to Summer Company if you

have an idea and want $3000 to launch it! After school,
consider Starter Company for $5000!

Flex-n-Gate Windsor
The Late Show - Ed Sullivan Theatre
Subsidies - Equity Finance

Canadian Subsidies
 Why the subsidy for Transit Windsor?
#1 - Sources of #2 - Sources of Expenses #3 Who does it benefit?
Revenue
 Why the subsidy for Transit Windsor?
#1 - Sources of #2 - Sources of Expenses #3 Who does it benefit?
Revenue
● Bus fare
○ Monthly
passes
○ day trip
○ Special
events -
tunnel
● Ads

● SUBSIDIES
(About half!)
 Why the subsidy for Transit Windsor?
#1 - Sources of #2 - Sources of Expenses #3 Who does it benefit?
Revenue
● Bus fare ● Buses
○ Monthly ● Labour
passes ○ Drivers
○ day trip ○ Workers at the terminal
○ Special ○ Mechanics
events - ○ Management
tunnel ● Gas
● Ads ● Maintenance
● Bus stops
● Bus station
● SUBSIDIES ○ Water
○ Electricity
○ Building maintenance
 Why the subsidy for Transit Windsor?
#1 - Sources of #2 - Sources of Expenses #3 Who does it benefit?
Revenue
● Bus fare ● Buses ● Opportunities for other
○ Monthly ● Labour businesses
passes ○ Drivers ● Students
○ day trip ○ Workers at the terminal ○ St Clair
○ Special ○ Mechanics ○ U of W
events - ○ Management ○ Windsor high schools
tunnel ● Gas ● People who can’t afford a
● Ads ● Maintenance vehicle
● Bus stops ● Disabled - mobility
● Bus station ● Elderly people
○ Water ● Teens
● SUBSIDIES ○ Electricity ● Environment
○ Building maintenance ● Traffic infrastructure
● Those who place ads on
bus
Updated Budget Details
Debt Factoring

Sometimes debtors pay late - or not at all. Creditors would

rather get back a portion of the money rather than nothing.
Rather than trying to collect the money on their own, a
company can sell the account receivable to a 3rd party for 80-
85% of the value. This can provide immediate cash flow,
reduce the risk of not getting paid, and save the efforts from
hunting down money from your debtors.

Some businesses immediately sell your account receivable to

a 3rd party (car dealerships, furniture stores) rather than
wait for payment. Tepperman’s does the finance in-house
 Leasing - Debt
This happens when one entity owns the asset (lessor) , and the other rents it from
them (lessee). It tends to be cheaper to
rent vehicles or equipment in the short to medium term. Another benefit is the
repairs and maintenance of the equipment is the responsibility of the lessor. If you
use an asset frequently and need it long term, purchasing it tends to be cheaper than
leasing. If you need it occasionally or in the short term, leasing tends to be a better
choice.

Sale and leaseback involves a business selling a particular fixed asset (to raise
finance) and immediately lease the property back. In essence, there is a transfer of
ownership without the physical asset leaving the business.

Hire Purchase allows a business to pay creditors in instalments. The asset is legally
the property of the creditor until all payments have been made. If the buyer defaults
on payments or falls behind, the creditor can repossess the asset.

Would a construction company ever use sale and leaseback?

True Story with Leasing - Carter Ducharme

PD Day?
Time to
make $$!
Pension Plans are often investors OTPP

Venture Capital
Long Term, Equity

Venture capitalists are either individuals or business’ who

specialize in seeking out viable business enterprises, and
through a process of scrutiny will provide the needed
finance for a stake in the “adventure”. The expectation of
venture capitalists is that they will provide the needed
finance for a business that will soar to unprecedented
heights and in the process replace the high risk taken in
the new business idea with the rewards of success.

However, the disadvantage of such an arrangement is that

the venture capitalists generally require a large portion of
the business to be turned over to them if not total control.
 Business Angels -
Long Term - Equity

Business Angels are wealthy individuals or groups

of wealthy individuals who are independently wealthy
and willing to support a business also for a stake
as opposed to business oriented organizations who are
actively engaged in the business of financing new
ventures.

The advantage of being associated with these

individuals and organizations is that the finance is
readily available and the required expertise in
operating the new business will most likely also be
provided. However, once again the disadvantage lies
in the stake taken in the business.
Crowdfunding - Equity
Government grant programs: Miami Marlins new stadium: Mark Zuckerberg's Mortgage
 Arguments for maintaining CBC Subsidies Arguments for eliminating CBC Subsidies

- Ideas can be put into the news - update - Money could be used elsewhere
news from a Canadian perspective - Biased news reporting - pro gov’t
- Progress with covid - Private media less biased. They can
- Journalists need steady streams of money challenge the government without
(so they use clickbait to make $). CBC threat of losing funding
doesn’t need to do that - Unfair advantage over the private
- Externalities - broadcast industry (cameras, companies who don’t get subsidized
editors, jobs) (actors, directors, musicians, - One opinion dominating the media
etc)
- Although skewed towards government, the
party in power does change
- Easier to access news - in particular for
remote areas. Private sector (for $) wouldn’t
service
- Protects Canadian culture
Conversation with a Venture Capitalist
Inside the mind of a venture
capitalist. Some great insights
along with some unpopular
opinions.

Theories about leadership,

motivation, economic development
and politics are woven throughout
this talk on finance.

I highly recommend giving it a

listen either on youtube or on Lex
Fridman’s podcast Start at 1:32:00 - or listen to the whole thing!
Trump’s Buildings
He has a blend of debt and
equity in all of these
properties
How to Choose a Source of Finance
When deciding on the type of finance, consider the following factors: Size,
Timeframe, Amount required, Gearing, External factors, Purpose of finance,
Cost of finance - or the acronym: STAGE PC

A. Pretend you are the CEO of a corporation in need of liquidity. Assess the
advantages and disadvantages of financing each proposal below.
1. Leasing equipment
2. Issuing more shares
3. Taking out an overdraft from the bank

B. If you were a bank manager and had to decide whether to give the
corporation a loan or not what information would you need to help you
decide?
Private Equity (not in course)

Inorganic or external sources of finance are means by which firms seek finance that are external to the business
organization. External Sources of finance may be either short-tem or long term. As defined in business, the short term is 0-
18 months, the mid-term 18 months to 5 years, and the long term 5 years and beyond.
When the business organization first begins operations, it seeks start-up capital, which is sourced externally. Borrowing
$500 from your grandmother and eventually making a fortune is an external sourcing of finance that some successful
entrepreneurs have written about in their autobiographies!

In making the determination of which source of finance is beneficial to the business organization, multiple factors have to be
considered. Among these are the Risk/Return ratio or the benefits derived from sourcing relative to the gains. Investment
Appraisal is a means by which business organizations can determine the best course of action.

Let us take a look at the options businesses have in raising finance externally, as there are clear advantages and
disadvantages, which therefore calls for the most appropriate from of finance for a given situation.