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8 Example: Single period rationing with non-divisible projects

8 Example: Single period rationing with non-divisible projects

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Chapter Roundup


Leasing is a commonly used source of finance.

We distinguish three types of leasing:




Operating leases (lessor responsible for maintaining asset)
Finance leases (lessee responsible for maintenance)
Sale and leaseback arrangements



The decision whether to lease or buy an asset is a financing decision which interacts with the investment
decision to buy the asset. The assumption is that the preferred financing method should be the one with
the lower PV of cost. We identify the least-cost financing option by comparing the cash flows of
purchasing and leasing. We assume that if the asset is purchased, it will be financed with a bank loan;
therefore the cash flows are discounted at an after-tax cost of borrowing.



DCF techniques can assist asset replacement decisions, to decide how frequently an asset should be
replaced. When an asset is being replaced with an identical asset, the equivalent annual cost method can
be used to calculate an optimum replacement cycle.



Capital rationing may occur due to internal factors (soft capital rationing) or external factors (hard capital
rationing).



When capital rationing occurs in a single period, projects are ranked in terms of profitability index. This
is the ratio of the NPV of a project to its investment cost. The projects with the highest ratios should be
selected for investment.

Quick Quiz
1

Who is responsible for the servicing of a leased asset in the case of:
(a)

An operating lease?

(b)

A finance lease?
The lessee

2

$4,697
$3,575
$4,111
$3,109

Hard capital rationing occurs when a restriction on an organisation's ability to invest capital funds is
caused by an internal budget ceiling imposed by management.

True
False
4

Profitability Index (PI) =

(1)
(2)

What are (1) and (2)?

220

The lessor

The net present value of the costs of operating a machine for the next three years is $10,724 at a cost of
capital of 15%. What is the equivalent annual cost of operating the machine?
A
B
C
D

3

or

11: Specific investment decisions  Part D Investment appraisal

5

Equivalent annual cost =

PV of cos ts over n years
n year annuity factor

Explain briefly what is meant by:
(a)
(b)

PV of costs
n year annuity factor

6

What is an indivisible project?

7

Give three reasons why hard capital rationing may occur.

8

What is the best way to find the optimal solution in a situation of single period rationing with indivisible
projects?

9

What is the best way to find the optimal solution in a situation of single period rationing with divisible
projects?

Part D Investment appraisal  11: Specific investment decisions

221

Answers to Quick Quiz
1

(a)
(b)

The lessor
The lessee

2

A

$10,724/2.283 = $4,697

3

False. This describes soft capital rationing.

4

(1)
(2)

Present value of cash inflows
Initial investment

5

(a)

The purchase cost, minus the present value of any subsequent disposal proceeds at the end of the
item's life

(b)

The annuity factor at the company's cost of capital, for the number of years of the item's life

6

A project that must be undertaken completely or not at all

7

Any three of:
(a)
(b)
(c)
(d)

Raising money through the stock market may not be possible if share prices are depressed.
There are restrictions on lending due to government control.
Lending institutions may consider the organisation to be too risky.
The costs associated with making small issues of capital may be too great.

8

Use trial and error and test the NPV available from different project combinations.

9

Rank the projects according to their profitability index.

Now try the questions below from the Practice Question Bank

222

Number

Level

Marks

Approximate time

Section A Q22

Examination

2

4 mins

Section C Q12

Examination

20

39 mins

Section C Q13

Examination

20

39 mins

11: Specific investment decisions  Part D Investment appraisal

P
A
R
T
E

Business finance

223

224

Sources of finance

Topic list

Syllabus reference

1 Short-term sources of finance

E1 (a)

2 Debt finance

E1 (b)

3 Venture capital
4 Equity finance and preference shares
5 Islamic finance

E1 (b)
E1 (b), (c)
E1 (d)

Introduction
In Part E of this study text we consider sources of finance. In this chapter we
will look at the distinction between short- and long-term sources of finance.
When sources of long-term finance are used, large sums are usually involved,
and so the financial manager needs to consider all the options available with
care, looking at the possible effects on the company in the long term.
If a company decides to raise new equity finance, it needs to consider which
method would be best for its circumstances.
Also considered here is the growth area of Islamic finance and how it differs
from the other forms of financing covered.

225

Study guide
Intellectual level
E1

Sources of and raising business finance

(a)

Identify and discuss the range of short-term sources of finance available
to businesses, including:

(i)

Overdraft

(ii)

Short-term loan

(iii)

Trade credit

(iv)

Lease finance

(b)

Identify and discuss the range of long-term sources of finance available to
businesses, including:

(i)

Equity finance

(ii)

Debt finance

(iii)

Lease finance

(iv)

Venture capital

(c)

Identify and discuss methods of raising equity finance, including:

(i)

Rights issue

(ii)

Placing

(iii)

Public offer

(iv)

Stock exchange listing

(d)

Identify and discuss methods of raising short- and long-term Islamic
finance, including:

(i)

Major difference between Islamic finance and the other forms of business
finance

(ii)

The concept of riba (interest) and how returns are made by Islamic
financial securities

(iii)

Islamic financial instruments available to businesses, including:
(i)

Murabaha (trade credit)

(ii)

Ijara (lease finance)

2

2

2

1

(iii) Mudaraba (equity finance)
(iv) Sukuk (debt finance)
(v)

Musharaka (venture capital)

Exam guide
Sources of finance are a major topic. You may be asked to describe appropriate sources of finance for a
particular company, and also discuss in general terms when different sources of finance should be utilised
and when they are likely to be available.
Performance objective 10 requires you to ‘source short-term finance to improve an organisation’s
liquidity’. You can apply the knowledge you obtain from this chapter of the text to help to demonstrate this
competence.

226

12: Sources of finance  Part E Business finance

1 Short-term sources of finance
FAST FORWARD

12/09

A range of short-term sources of finance are available to businesses including overdrafts, short-term
loans, trade credit and operating lease finance.
Short-term finance is usually needed for businesses to run their day to day operations including payment
of wages to employees, inventory ordering and supplies. Businesses with seasonal peaks and troughs and
those engaged in international trade are likely to be heavy users of short-term finance.

1.1 Overdrafts
Where payments from a current account exceed income to the account for a temporary period, the bank
may agree to finance a deficit balance on the account by means of an overdraft. Overdrafts are the most
important source of short-term finance available to businesses. They can be arranged relatively quickly
and offer a level of flexibility with regard to the amount borrowed at any time, while interest is only paid
when the account is overdrawn.
OVERDRAFTS
Amount

The bank specifies an overdraft limit. The overdrawn (negative) balance on the
account cannot exceed this limit. The bank usually decides the limit with reference
to the borrower's known income. Overdraft borrowing is through the borrower's
normal business bank account.

Margin

Interest charged at the bank's administrative base rate plus a margin. This rate is
usually higher than the rate for a short-term bank loan.
Interest is calculated daily on the amount overdrawn and is charged to the
borrower's account quarterly (or monthly). An additional fee may be charged for
arranging a large-size overdraft facility.

Purpose

Generally to cover short-term deficits in cash flows from normal business
operations. The borrower may not want to retain large amounts of cash in a bank
account, earning no interest; therefore some negative cash balances may occur.

Repayment

Technically repayable on demand. If a bank ends an overdraft facility without
warning, the borrower could face a risk of insolvency.

Security

Depends on size of facility. The bank may ask for security (collateral) but often does
not.

Benefits

The customer has flexible means of short-term borrowing; the bank has to accept
fluctuations in amount of lending.

By providing an overdraft facility to a customer, the bank is committing itself to providing an overdraft to
the customer whenever the customer wants it, up to the agreed limit. The bank will earn interest on the
lending, but only to the extent that the customer uses the facility and goes into their overdraft. If the
customer does not go into their overdraft, the bank cannot charge interest.
The bank will generally charge a commitment fee when a customer is granted an overdraft facility or an
increase in their overdraft facility. This is a fee for granting an overdraft facility and agreeing to provide the
customer with funds if and whenever they need them.

Part E Business finance  12: Sources of finance

227

1.1.1 Overdrafts and the operating cycle
Many businesses require their bank to provide financial assistance for normal trading over the operating
cycle.
For example, suppose that a business has the following working capital position.
$
Inventories and trade receivables
Bank overdraft
Trade payables
Working capital

$
10,000

1,000
3,000
4,000
6,000

It now buys inventory costing $2,500 for cash, using its overdraft. Working capital remains the same,
$6,000, although the bank's financial stake has risen from $1,000 to $3,500.
$
$
Inventories and trade receivables
12,500
Bank overdraft
3,500
Trade payables
3,000
6,500
Working capital
6,000
A bank overdraft provides support for normal trading finance. In this example, finance for normal trading
rises from $(10,000  3,000) = $7,000 to $(12,500  3,000) = $9,500 and the bank's contribution rises
from $1,000 out of $7,000 to $3,500 out of $9,500.
A feature of bank lending to support normal trading finance is that the amount of the overdraft required at
any time will depend on the cash flows of the business – the timing of receipts and payments, seasonal
variations in trade patterns, and so on. The purpose of the overdraft is to bridge the gap between cash
payments and cash receipts.

1.1.2 Solid core overdrafts
When a business customer has an overdraft facility, and the account is always in overdraft, then it has a
solid core (or hard core) overdraft. For example, suppose that the account of a company has the following
record for the previous year.
Average
Debit
balance
Range
revenue
Quarter to
$
$
$
$
31 March 20X5
40,000 debit
70,000 debit

20,000 debit
600,000
30 June 20X5
50,000 debit
80,000 debit

25,000 debit
500,000
30 September 20X5
75,000 debit
105,000 debit

50,000 debit
700,000
31 December 20X5
80,000 debit
110,000 debit

60,000 debit
550,000
These figures show that the account has been permanently in overdraft, and the hard core of the overdraft
has been rising steeply over the course of the year.
If the hard core element of the overdraft appears to be becoming a long-term feature of the business, the
bank might wish, after discussions with the customer, to convert the hard core of the overdraft into a
loan, thus giving formal recognition to its more permanent nature. Otherwise annual reductions in the
hard core of an overdraft would typically be a requirement of the bank.

1.2 Short-term loans
A term loan is a loan for a fixed amount for a specified period, usually from a bank. The loan may have a
specific purpose, such as the purchase of an asset. It is drawn in full at the beginning of the loan period
and repaid at a specified time or in defined instalments. Term loans are offered with a variety of
repayment schedules. Often, the interest and capital repayments are predetermined.

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12: Sources of finance  Part E Business finance

The bank establishes a separate loan account for the loan, charging interest to the account and setting off
loan payments against the balance on the account.
The main advantage of lending on a loan account for the bank is that it makes monitoring and control of
the advance much easier, because the loan cash flows are recorded in a separate account. The bank can
see immediately when the customer is falling behind with their repayments, or struggling to make the
payments. With overdraft lending, a customer's difficulties might be obscured for some time by the variety
of transactions on their current account.
(a)

The customer knows what they will be expected to pay back at regular intervals and the bank can
also predict its future income with more certainty (depending on whether the interest rate is fixed
or floating).

(b)

Once the loan is agreed, the term of the loan must be adhered to, provided that the customer does
not fall behind with their repayments. It is not repayable on demand by the bank.

(c)

Because the bank will be committing its funds to a customer for a number of years, it may wish to
insist on building certain written safeguards into the loan agreement, to prevent the customer
from becoming overextended with their borrowing during the course of the loan. A loan covenant
is a condition that the borrower must comply with. If the borrower does not act in accordance with
the covenants, the loan can be considered in default and the bank can demand payment.

1.3 Overdrafts and short-term loans compared
A customer might ask the bank for an overdraft facility when the bank would wish to suggest a loan
instead; alternatively, a customer might ask for a loan when an overdraft would be more appropriate.
(a)

In most cases, when a customer wants finance to help with 'day to day' trading and cash flow
needs, an overdraft would be the appropriate method of financing. The customer should not be
short of cash all the time, and should expect to be in credit in some days, but in need of an
overdraft on others.

(b)

When a customer wants to borrow from a bank for only a short period of time, even for the
purchase of a major fixed asset, such as an item of plant or machinery, an overdraft facility might
be more suitable than a loan, because the customer will stop paying interest as soon as their
account goes into credit.

1.3.1 Advantages of an overdraft over a loan
(a)

The customer only pays interest when they are overdrawn.

(b)

The bank has the flexibility to review the customer's overdraft facility periodically, and perhaps
agree to additional facilities, or insist on a reduction in the facility.

(c)

An overdraft can do the same job as a loan: a facility can simply be renewed every time it comes
up for review.

Bear in mind, however, that overdrafts are normally repayable on demand.

1.3.2 Advantages of a loan for longer-term lending
(a)

Both the customer and the bank know exactly what the repayments of the loan will be and how
much interest is payable, and when. This makes planning (budgeting) simpler.

(b)

The interest rate on the loan balance is likely to be lower than the interest charged on overdrawn
balances. The comparative cost therefore depends on the size and duration of borrowing
requirements.

(c)

The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft
facility before they are in a position to repay what is owed. There is an element of 'security' or 'peace
of mind' in being able to arrange a loan for an agreed term.

(d)

Loans normally carry a facility letter setting out the precise terms of the agreement.

Part E Business finance  12: Sources of finance

229

However, a mix of overdrafts and loans might be suggested in some cases. Consider a case where a
business asks for a loan, perhaps to purchase a shop with inventory. The banker might wish to suggest a
loan to help with the purchase of the shop, but that inventory ought to be financed by an overdraft facility.
The offer of part-loan part-overdraft is an option that might be well worth considering.

1.3.3 Calculation of repayments on a loan
We can use an annuity table to calculate the repayments on a loan.
For example, a $30,000 loan is taken out by a business at a rate of 12% over 5 years. What will be the
annual payment, assuming that payments are made every 12 months and the loan provides for gradual
repayment over the term of the loan?
The annuity factor for 12% over 5 years is 3.605. Therefore $30,000 = 3.605  annual payment.
Annual payment

30,000
3.605

=

= $8,321.78

1.3.4 The split between interest and capital repayment
A loan of $100,000 is to be repaid to the bank, over five years, in equal annual year-end instalments made
up of capital repayments and interest at 9% pa.
The annual payment =

$100,000
 $25,707
3.890

Each payment can then be split between the repayment of capital and interest.
Year

1
2
3
4
5

Balance b/f
$
100,000
83,293
65,082
45,232
23,596

Interest @ 9%
$
9,000
7,496
5,857
4,071
2,111*

Annual payment
$
(25,707)
(25,707)
(25,707)
(25,707)
(25,707)

Balance c/f
$
83,293
65,082
45,232
23,596

* Rounding difference

1.4 Trade credit
Trade credit is a major source of short-term finance for a business. Current assets such as raw materials
may be purchased on credit, with payment terms normally varying from between 30 and 90 days. Trade
credit therefore represents an interest-free short-term loan. In a period of high inflation, purchasing via
trade credit will be very helpful in keeping costs down. However, it is important to take into account the
loss of discounts suppliers offer for early payment.
Unacceptable delays in payment will worsen a company's credit rating and additional credit may become
difficult to obtain.

1.5 Leasing

6/11

Rather than buying an asset outright, using either available cash resources or borrowed funds, a business
may lease an asset. Leasing is a popular source of finance.
Leasing can be defined as a contract between lessor and lessee for hire of a specific asset selected from a
manufacturer or vendor of such assets by the lessee. The lessor retains ownership of the asset. The lessee
has possession and use of the asset on payment of specified rentals over a period. Operating leases are in
effect a short-term source of finance for non-current assets, and finance leases are a long-term source of
finance. This is because the lessor purchases the asset and the lessee can use it without having to incur
the initial cost immediately.

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12: Sources of finance  Part E Business finance