Chapter 7 - Sources of finance

Chapter objectives
Structure of the chapter
Sources of funds
Ordinary (equity) shares
Loan stock
Retained earnings
Bank lending
Leasing
ire purchase
!overn"ent assistance
#enture capital
$ranchising
%ey ter"s
Sourcing "oney "ay be done for a variety of reasons& 'raditional areas of need "ay be
for capital asset acquire"ent ( ne) "achinery or the construction of a ne) building or
depot& 'he develop"ent of ne) products can be enor"ously costly and here again
capital "ay be required& *or"ally+ such develop"ents are financed internally+ )hereas
capital for the acquisition of "achinery "ay co"e fro" e,ternal sources& -n this day and
age of tight liquidity+ "any organisations have to look for short ter" capital in the )ay of
overdraft or loans in order to provide a cash flo) cushion& -nterest rates can vary fro"
organisation to organisation and also according to purpose&
Chapter objectives
'his chapter is intended to provide.
/n introduction to the different sources of finance available to "anage"ent+ both
internal and e,ternal
/n overvie) of the advantages and disadvantages of the different sources of funds
/n understanding of the factors governing the choice bet)een different sources of
funds&
Structure of the chapter
'his final chapter starts by looking at the various for"s of 0shares0 as a "eans to raise
ne) capital and retained earnings as another source& o)ever+ )hilst these "ay be
0traditional0 )ays of raising funds+ they are by no "eans the only ones& 'here are "any
"ore sources available to co"panies )ho do not )ish to beco"e 0public0 by "eans of
share issues& 'hese alternatives include bank borro)ing+ govern"ent assistance+
venture capital and franchising& /ll have their o)n advantages and disadvantages and
degrees of risk attached&
Sources of funds
/ co"pany "ight raise ne) funds fro" the follo)ing sources.
'he capital "arkets.
i) ne) share issues+ for e,a"ple+ by co"panies acquiring a stock "arket listing for the
first ti"e
ii) rights issues
Loan stock
Retained earnings
Bank borro)ing
!overn"ent sources
Business e,pansion sche"e funds
#enture capital
$ranchising&
Ordinary (equity) shares
Ordinary shares are issued to the o)ners of a co"pany& 'hey have a no"inal or 1face1
value+ typically of 23 or 45 cents& 'he "arket value of a quoted co"pany1s shares bears
no relationship to their no"inal value+ e,cept that )hen ordinary shares are issued for
cash+ the issue price "ust be equal to or be "ore than the no"inal value of the shares&
Deferred ordinary shares
are a for" of ordinary shares+ )hich are entitled to a dividend only after a certain date or
if profits rise above a certain a"ount& #oting rights "ight also differ fro" those attached
to other ordinary shares&
Ordinary shareholders put funds into their co"pany.
a) by paying for a ne) issue of shares
b) through retained profits&
Si"ply retaining profits+ instead of paying the" out in the for" of dividends+ offers an
i"portant+ si"ple lo)(cost source of finance+ although this "ethod "ay not provide
enough funds+ for e,a"ple+ if the fir" is seeking to gro)&
/ ne) issue of shares "ight be "ade in a variety of different circu"stances.
a) 'he co"pany "ight )ant to raise "ore cash& -f it issues ordinary shares for cash+
should the shares be issued pro rata to e,isting shareholders+ so that control or
o)nership of the co"pany is not affected6 -f+ for e,a"ple+ a co"pany )ith 755+555
ordinary shares in issue decides to issue 45+555 ne) shares to raise cash+ should it offer
the ne) shares to e,isting shareholders+ or should it sell the" to ne) shareholders
instead6
i) -f a co"pany sells the ne) shares to e,isting shareholders in proportion to their
e,isting shareholding in the co"pany+ )e have a rights issue. -n the e,a"ple above+ the
45+555 shares )ould be issued as a one(in(four rights issue+ by offering shareholders
one ne) share for every four shares they currently hold&
ii) -f the nu"ber of ne) shares being issued is s"all co"pared to the nu"ber of shares
already in issue+ it "ight be decided instead to sell the" to ne) shareholders+ since
o)nership of the co"pany )ould only be "ini"ally affected&
b) 'he co"pany "ight )ant to issue shares partly to raise cash+ but "ore i"portantly to
float1 its shares on a stick e,change&
c) 'he co"pany "ight issue ne) shares to the shareholders of another co"pany+ in
order to take it over&
New shares issues
/ co"pany seeking to obtain additional equity funds "ay be.
a) an unquoted co"pany )ishing to obtain a Stock 8,change quotation
b) an unquoted co"pany )ishing to issue ne) shares+ but )ithout obtaining a Stock
8,change quotation
c) a co"pany )hich is already listed on the Stock 8,change )ishing to issue additional
ne) shares&
'he "ethods by )hich an unquoted co"pany can obtain a quotation on the stock
"arket are.
a) an offer for sale
b) a prospectus issue
c) a placing
d) an introduction&
Offers for sale.
/n offer for sale is a "eans of selling the shares of a co"pany to the public&
a) /n unquoted co"pany "ay issue shares+ and then sell the" on the Stock 8,change+
to raise cash for the co"pany& /ll the shares in the co"pany+ not just the ne) ones+
)ould then beco"e "arketable&
b) Shareholders in an unquoted co"pany "ay sell so"e of their e,isting shares to the
general public& 9hen this occurs+ the co"pany is not raising any ne) funds+ but just
providing a )ider "arket for its e,isting shares (all of )hich )ould beco"e "arketable)+
and giving e,isting shareholders the chance to cash in so"e or all of their invest"ent in
their co"pany&
9hen co"panies 1go public1 for the first ti"e+ a 1large1 issue )ill probably take the for" of
an offer for sale& / s"aller issue is "ore likely to be a placing+ since the a"ount to be
raised can be obtained "ore cheaply if the issuing house or other sponsoring fir"
approaches selected institutional investors privately&
Rihts issues
/ rights issue provides a )ay of raising ne) share capital by "eans of an offer to
e,isting shareholders+ inviting the" to subscribe cash for ne) shares in proportion to
their e,isting holdings&
$or e,a"ple+ a rights issue on a one(for(four basis at 7:5c per share )ould "ean that a
co"pany is inviting its e,isting shareholders to subscribe for one ne) share for every
four shares they hold+ at a price of 7:5c per ne) share&
/ co"pany "aking a rights issue "ust set a price )hich is lo) enough to secure the
acceptance of shareholders+ )ho are being asked to provide e,tra funds+ but not too lo)+
so as to avoid e,cessive dilution of the earnings per share&
!reference shares
;reference shares have a fi,ed percentage dividend before any dividend is paid to the
ordinary shareholders& /s )ith ordinary shares a preference dividend can only be paid if
sufficient distributable profits are available+ although )ith 1cu"ulative1 preference shares
the right to an unpaid dividend is carried for)ard to later years& 'he arrears of dividend
on cu"ulative preference shares "ust be paid before any dividend is paid to the
ordinary shareholders&
$ro" the co"pany1s point of vie)+ preference shares are advantageous in that.
<ividends do not have to be paid in a year in )hich profits are poor+ )hile this is not the
case )ith interest pay"ents on long ter" debt (loans or debentures)&
Since they do not carry voting rights+ preference shares avoid diluting the control of
e,isting shareholders )hile an issue of equity shares )ould not&
=nless they are redee"able+ issuing preference shares )ill lo)er the co"pany1s
gearing& Redee"able preference shares are nor"ally treated as debt )hen gearing is
calculated&
'he issue of preference shares does not restrict the co"pany1s borro)ing po)er+ at
least in the sense that preference share capital is not secured against assets in the
business&
'he non(pay"ent of dividend does not give the preference shareholders the right to
appoint a receiver+ a right )hich is nor"ally given to debenture holders&
o)ever+ dividend pay"ents on preference shares are not ta, deductible in the )ay that
interest pay"ents on debt are& $urther"ore+ for preference shares to be attractive to
investors+ the level of pay"ent needs to be higher than for interest on debt to
co"pensate for the additional risks&
$or the investor+ preference shares are less attractive than loan stock because.
they cannot be secured on the co"pany1s assets
the dividend yield traditionally offered on preference dividends has been "uch too lo)
to provide an attractive invest"ent co"pared )ith the interest yields on loan stock in
vie) of the additional risk involved&
"oan stoc#
Loan stock is long(ter" debt capital raised by a co"pany for )hich interest is paid+
usually half yearly and at a fi,ed rate& olders of loan stock are therefore long(ter"
creditors of the co"pany&
Loan stock has a no"inal value+ )hich is the debt o)ed by the co"pany+ and interest is
paid at a stated 0coupon yield0 on this a"ount& $or e,a"ple+ if a co"pany issues 35>
loan stocky the coupon yield )ill be 35> of the no"inal value of the stock+ so that 2355
of stock )ill receive 235 interest each year& 'he rate quoted is the gross rate+ before ta,&
<ebentures are a for" of loan stock+ legally defined as the )ritten ackno)ledge"ent of
a debt incurred by a co"pany+ nor"ally containing provisions about the pay"ent of
interest and the eventual repay"ent of capital&
Debentures with a f$oatin rate of interest
'hese are debentures for )hich the coupon rate of interest can be changed by the
issuer+ in accordance )ith changes in "arket rates of interest& 'hey "ay be attractive to
both lenders and borro)ers )hen interest rates are volatile&
Security
Loan stock and debentures )ill often be secured. Security "ay take the for" of either a
fixed charge or a floating charge.
a) %i&ed chare' Security )ould be related to a specific asset or group of assets+
typically land and buildings& 'he co"pany )ould be unable to dispose of the asset
)ithout providing a substitute asset for security+ or )ithout the lender1s consent&
b) %$oatin chare' 9ith a floating charge on certain assets of the co"pany (for
e,a"ple+ stocks and debtors)+ the lender1s security in the event of a default pay"ent is
)hatever assets of the appropriate class the co"pany then o)ns (provided that another
lender does not have a prior charge on the assets)& 'he co"pany )ould be able+
ho)ever+ to dispose of its assets as it chose until a default took place& -n the event of a
default+ the lender )ould probably appoint a receiver to run the co"pany rather than lay
clai" to a particular asset&
(he rede)ption of $oan stoc#
Loan stock and debentures are usually redee"able& 'hey are issued for a ter" of ten
years or "ore+ and perhaps 74 to ?5 years& /t the end of this period+ they )ill 0"ature0
and beco"e redee"able (at par or possibly at a value above par)&
@ost redee"able stocks have an earliest and latest rede"ption date& $or e,a"ple+ 3:>
<ebenture Stock 755AB5C is redee"able+ at any ti"e bet)een the earliest specified date
(in 755A) and the latest date (in 755C)& 'he issuing co"pany can choose the date& 'he
decision by a co"pany )hen to redee" a debt )ill depend on.
a) ho) "uch cash is available to the co"pany to repay the debt
b) the no"inal rate of interest on the debt& -f the debentures pay 3:> no"inal interest
and the current rate of interest is lo)er+ say 35>+ the co"pany "ay try to raise a ne)
loan at 35> to redee" the debt )hich costs 3:>& On the other hand+ if current interest
rates are 75>+ the co"pany is unlikely to redee" the debt until the latest date possible+
because the debentures )ould be a cheap source of funds&
'here is no guarantee that a co"pany )ill be able to raise a ne) loan to pay off a
"aturing debt+ and one ite" to look for in a co"pany1s balance sheet is the rede"ption
date of current loans+ to establish ho) "uch ne) finance is likely to be needed by the
co"pany+ and )hen&
@ortgages are a specific type of secured loan& Co"panies place the title deeds of
freehold or long leasehold property as security )ith an insurance co"pany or "ortgage
broker and receive cash on loan+ usually repayable over a specified period& @ost
organisations o)ning property )hich is unencu"bered by any charge should be able to
obtain a "ortgage up to t)o thirds of the value of the property&
/s far as co"panies are concerned+ debt capital is a potentially attractive source of
finance because interest charges reduce the profits chargeable to corporation ta,&
Retained earnins
$or any co"pany+ the a"ount of earnings retained )ithin the business has a direct
i"pact on the a"ount of dividends& ;rofit re(invested as retained earnings is profit that
could have been paid as a dividend& 'he "ajor reasons for using retained earnings to
finance ne) invest"ents+ rather than to pay higher dividends and then raise ne) equity
for the ne) invest"ents+ are as follo)s.
a) 'he "anage"ent of "any co"panies believes that retained earnings are funds )hich
do not cost anything+ although this is not true& o)ever+ it is true that the use of retained
earnings as a source of funds does not lead to a pay"ent of cash&
b) 'he dividend policy of the co"pany is in practice deter"ined by the directors& $ro"
their standpoint+ retained earnings are an attractive source of finance because
invest"ent projects can be undertaken )ithout involving either the shareholders or any
outsiders&
c) 'he use of retained earnings as opposed to ne) shares or debentures avoids issue
costs&
d) 'he use of retained earnings avoids the possibility of a change in control resulting
fro" an issue of ne) shares&
/nother factor that "ay be of i"portance is the financial and ta,ation position of the
co"pany1s shareholders& -f+ for e,a"ple+ because of ta,ation considerations+ they )ould
rather "ake a capital profit ()hich )ill only be ta,ed )hen shares are sold) than receive
current inco"e+ then finance through retained earnings )ould be preferred to other
"ethods&
/ co"pany "ust restrict its self(financing through retained profits because shareholders
should be paid a reasonable dividend+ in line )ith realistic e,pectations+ even if the
directors )ould rather keep the funds for re(investing& /t the sa"e ti"e+ a co"pany that
is looking for e,tra funds )ill not be e,pected by investors (such as banks) to pay
generous dividends+ nor over(generous salaries to o)ner(directors&
*an# $endin
Borro)ings fro" banks are an i"portant source of finance to co"panies& Bank lending is
still "ainly short ter"+ although "ediu"(ter" lending is quite co""on these days&
Short ter" lending "ay be in the for" of.
a) an overdraft+ )hich a co"pany should keep )ithin a li"it set by the bank& -nterest is
charged (at a variable rate) on the a"ount by )hich the co"pany is overdra)n fro" day
to dayD
b) a short(ter" loan+ for up to three years&
@ediu"(ter" loans are loans for a period of fro" three to ten years& 'he rate of interest
charged on "ediu"(ter" bank lending to large co"panies )ill be a set "argin+ )ith the
siEe of the "argin depending on the credit standing and riskiness of the borro)er& / loan
"ay have a fi,ed rate of interest or a variable interest rate+ so that the rate of interest
charged )ill be adjusted every three+ si,+ nine or t)elve "onths in line )ith recent
"ove"ents in the Base Lending Rate&
Lending to s"aller co"panies )ill be at a "argin above the bank1s base rate and at
either a variable or fi,ed rate of interest& Lending on overdraft is al)ays at a variable
rate& / loan at a variable rate of interest is so"eti"es referred to as a floating rate loan.
Longer(ter" bank loans )ill so"eti"es be available+ usually for the purchase of
property+ )here the loan takes the for" of a "ortgage& 9hen a banker is asked by a
business custo"er for a loan or overdraft facility+ he )ill consider several factors+ kno)n
co""only by the "ne"onic !+R(S,
( !urpose
( +"ount
( Repay"ent
( (er"
( Security
! 'he purpose of the loan / loan request )ill be refused if the purpose of the loan is not
acceptable to the bank&
+ 'he a"ount of the loan& 'he custo"er "ust state e,actly ho) "uch he )ants to borro)& 'he
banker "ust verify+ as far as he is able to do so+ that the a"ount required to "ake the proposed
invest"ent has been esti"ated correctly&
R o) )ill the loan be repaid6 9ill the custo"er be able to obtain sufficient inco"e to "ake the
necessary repay"ents6
( 9hat )ould be the duration of the loan6 'raditionally+ banks have offered short(ter" loans and
overdrafts+ although "ediu"(ter" loans are no) quite co""on&
S <oes the loan require security6 -f so+ is the proposed security adequate6
"easin
/ lease is an agree"ent bet)een t)o parties+ the 0lessor0 and the 0lessee0& 'he lessor
o)ns a capital asset+ but allo)s the lessee to use it& 'he lessee "akes pay"ents under
the ter"s of the lease to the lessor+ for a specified period of ti"e&
Leasing is+ therefore+ a for" of rental& Leased assets have usually been plant and
"achinery+ cars and co""ercial vehicles+ but "ight also be co"puters and office
equip"ent& 'here are t)o basic for"s of lease. 0operating leases0 and 0finance leases0&
Operatin $eases
Operating leases are rental agree"ents bet)een the lessor and the lessee )hereby.
a) the lessor supplies the equip"ent to the lessee
b) the lessor is responsible for servicing and "aintaining the leased equip"ent
c) the period of the lease is fairly short+ less than the econo"ic life of the asset+ so that
at the end of the lease agree"ent+ the lessor can either
i) lease the equip"ent to so"eone else+ and obtain a good rent for it+ or
ii) sell the equip"ent secondhand&
%inance $eases
$inance leases are lease agree"ents bet)een the user of the leased asset (the lessee)
and a provider of finance (the lessor) for "ost+ or all+ of the asset1s e,pected useful life&
Suppose that a co"pany decides to obtain a co"pany car and finance the acquisition by
"eans of a finance lease& / car dealer )ill supply the car& / finance house )ill agree to
act as lessor in a finance leasing arrange"ent+ and so )ill purchase the car fro" the
dealer and lease it to the co"pany& 'he co"pany )ill take possession of the car fro"
the car dealer+ and "ake regular pay"ents ("onthly+ quarterly+ si, "onthly or annually)
to the finance house under the ter"s of the lease&
Other i"portant characteristics of a finance lease.
a) 'he lessee is responsible for the upkeep+ servicing and "aintenance of the asset& 'he
lessor is not involved in this at all&
b) 'he lease has a pri"ary period+ )hich covers all or "ost of the econo"ic life of the
asset& /t the end of the lease+ the lessor )ould not be able to lease the asset to
so"eone else+ as the asset )ould be )orn out& 'he lessor "ust+ therefore+ ensure that
the lease pay"ents during the pri"ary period pay for the full cost of the asset as )ell as
providing the lessor )ith a suitable return on his invest"ent&
c) -t is usual at the end of the pri"ary lease period to allo) the lessee to continue to
lease the asset for an indefinite secondary period+ in return for a very lo) no"inal rent&
/lternatively+ the lessee "ight be allo)ed to sell the asset on the lessor1s behalf (since
the lessor is the o)ner) and to keep "ost of the sale proceeds+ paying only a s"all
percentage (perhaps 35>) to the lessor&
-hy )iht $easin be popu$ar
'he attractions of leases to the supplier of the equip"ent+ the lessee and the lessor are
as follo)s.
'he supplier of the equip"ent is paid in full at the beginning& 'he equip"ent is sold to
the lessor+ and apart fro" obligations under guarantees or )arranties+ the supplier has
no further financial concern about the asset&
'he lessor invests finance by purchasing assets fro" suppliers and "akes a return out
of the lease pay"ents fro" the lessee& ;rovided that a lessor can find lessees )illing to
pay the a"ounts he )ants to "ake his return+ the lessor can "ake good profits& e )ill
also get capital allo)ances on his purchase of the equip"ent&
Leasing "ight be attractive to the lessee.
i) if the lessee does not have enough cash to pay for the asset+ and )ould have difficulty
obtaining a bank loan to buy it+ and so has to rent it in one )ay or another if he is to have
the use of it at allD or
ii) if finance leasing is cheaper than a bank loan& 'he cost of pay"ents under a loan
"ight e,ceed the cost of a lease&
Operating leases have further advantages.
'he leased equip"ent does not need to be sho)n in the lessee1s published balance
sheet+ and so the lessee1s balance sheet sho)s no increase in its gearing ratio&
'he equip"ent is leased for a shorter period than its e,pected useful life& -n the case of
high(technology equip"ent+ if the equip"ent beco"es out(of(date before the end of its
e,pected life+ the lessee does not have to keep on using it+ and it is the lessor )ho "ust
bear the risk of having to sell obsolete equip"ent secondhand&
'he lessee )ill be able to deduct the lease pay"ents in co"puting his ta,able profits&
.ire purchase
ire purchase is a for" of instal"ent credit& ire purchase is si"ilar to leasing+ )ith the
e,ception that o)nership of the goods passes to the hire purchase custo"er on
pay"ent of the final credit instal"ent+ )hereas a lessee never beco"es the o)ner of the
goods&
ire purchase agree"ents usually involve a finance house&
i) 'he supplier sells the goods to the finance house&
ii) 'he supplier delivers the goods to the custo"er )ho )ill eventually purchase the"&
iii) 'he hire purchase arrange"ent e,ists bet)een the finance house and the custo"er&
'he finance house )ill al)ays insist that the hirer should pay a deposit to)ards the
purchase price& 'he siEe of the deposit )ill depend on the finance co"pany1s policy and
its assess"ent of the hirer& 'his is in contrast to a finance lease+ )here the lessee "ight
not be required to "ake any large initial pay"ent&
/n industrial or co""ercial business can use hire purchase as a source of finance& 9ith
industrial hire purchase+ a business custo"er obtains hire purchase finance fro" a
finance house in order to purchase the fi,ed asset& !oods bought by businesses on hire
purchase include co"pany vehicles+ plant and "achinery+ office equip"ent and far"ing
"achinery&
/overn)ent assistance
'he govern"ent provides finance to co"panies in cash grants and other for"s of direct
assistance+ as part of its policy of helping to develop the national econo"y+ especially in
high technology industries and in areas of high une"ploy"ent& $or e,a"ple+ the
-ndigenous Business <evelop"ent Corporation of Fi"bab)e (-B<C) )as set up by the
govern"ent to assist s"all indigenous businesses in that country&
0enture capita$
#enture capital is "oney put into an enterprise )hich "ay all be lost if the enterprise
fails& / business"an starting up a ne) business )ill invest venture capital of his o)n+ but
he )ill probably need e,tra funding fro" a source other than his o)n pocket& o)ever+
the ter" 1venture capital1 is "ore specifically associated )ith putting "oney+ usually in
return for an equity stake+ into a ne) business+ a "anage"ent buy(out or a "ajor
e,pansion sche"e&
'he institution that puts in the "oney recognises the ga"ble inherent in the funding&
'here is a serious risk of losing the entire invest"ent+ and it "ight take a long ti"e
before any profits and returns "aterialise& But there is also the prospect of very high
profits and a substantial return on the invest"ent& / venture capitalist )ill require a high
e,pected rate of return on invest"ents+ to co"pensate for the high risk&
/ venture capital organisation )ill not )ant to retain its invest"ent in a business
indefinitely+ and )hen it considers putting "oney into a business venture+ it )ill also
consider its 0e,it0+ that is+ ho) it )ill be able to pull out of the business eventually (after
five to seven years+ say) and realise its profits& 8,a"ples of venture capital
organisations are. @erchant Bank of Central /frica Ltd and /nglo /"erican Corporation
Services Ltd&
9hen a co"pany1s directors look for help fro" a venture capital institution+ they "ust
recognise that.
the institution )ill )ant an equity stake in the co"pany
it )ill need convincing that the co"pany can be successful
it "ay )ant to have a representative appointed to the co"pany1s board+ to look after its
interests&
'he directors of the co"pany "ust then contact venture capital organisations+ to try and
find one or "ore )hich )ould be )illing to offer finance& / venture capital organisation
)ill only give funds to a co"pany that it believes can succeed+ and before it )ill "ake
any definite offer+ it )ill )ant fro" the co"pany "anage"ent.
a) a business plan
b) details of ho) "uch finance is needed and ho) it )ill be used
c) the "ost recent trading figures of the co"pany+ a balance sheet+ a cash flo) forecast
and a profit forecast
d) details of the "anage"ent tea"+ )ith evidence of a )ide range of "anage"ent skills
e) details of "ajor shareholders
f) details of the co"pany1s current banking arrange"ents and any other sources of
finance
g) any sales literature or publicity "aterial that the co"pany has issued&
/ high percentage of requests for venture capital are rejected on an initial screening+ and
only a s"all percentage of all requests survive both this screening and further
investigation and result in actual invest"ents&
%ranchisin
$ranchising is a "ethod of e,panding business on less capital than )ould other)ise be
needed& $or suitable businesses+ it is an alternative to raising e,tra capital for gro)th&
$ranchisors include Budget Rent(a(Car+ 9i"py+ *ando1s Chicken and Chicken -nn&
=nder a franchising arrange"ent+ a franchisee pays a franchisor for the right to operate
a local business+ under the franchisor1s trade na"e& 'he franchisor "ust bear certain
costs (possibly for architect1s )ork+ establish"ent costs+ legal costs+ "arketing costs and
the cost of other support services) and )ill charge the franchisee an initial franchise fee
to cover set(up costs+ relying on the subsequent regular pay"ents by the franchisee for
an operating profit& 'hese regular pay"ents )ill usually be a percentage of the
franchisee1s turnover&
/lthough the franchisor )ill probably pay a large part of the initial invest"ent cost of a
franchisee1s outlet+ the franchisee )ill be e,pected to contribute a share of the
invest"ent hi"self& 'he franchisor "ay )ell help the franchisee to obtain loan capital to
provide his(share of the invest"ent cost&
'he advantages of franchises to the franchisor are as follo)s.
'he capital outlay needed to e,pand the business is reduced substantially&
'he i"age of the business is i"proved because the franchisees )ill be "otivated to
achieve good results and )ill have the authority to take )hatever action they think fit to
i"prove the results&
'he advantage of a franchise to a franchisee is that he obtains o)nership of a business
for an agreed nu"ber of years (including stock and pre"ises+ although pre"ises "ight
be leased fro" the franchisor) together )ith the backing of a large organisation1s
"arketing effort and e,perience& 'he franchisee is able to avoid so"e of the "istakes of
"any s"all businesses+ because the franchisor has already learned fro" its o)n past
"istakes and developed a sche"e that )orks&
*o) atte"pt e,ercise A&3&
1&ercise 7,2 Sources of finance
Outdoor Living Ltd&+ an o)ner("anaged co"pany+ has developed a ne) type of heating
using solar po)er+ and has financed the develop"ent stages fro" its o)n resources&
@arket research indicates the possibility of a large volu"e of de"and and a significant
a"ount of additional capital )ill be needed to finance production&
/dvise Outdoor Living Ltd& on.
a) the advantages and disadvantages of loan or equity capital
b) the various types of capital likely to be available and the sources fro" )hich they
"ight be obtained
c) the "ethod(s) of finance likely to be "ost satisfactory to both Outdoor Living Ltd& and
the provider of funds&
3ey ter)s
Bank lending
Capital "arkets
<ebentures
<eferred ordinary shares
$ranchising
!overn"ent assistance
ire purchase
Loan stocks
*e) share issue
Ordinary shares
;/R'S
;reference shares
Retained earnings
Rights issue
Sources of funds
#enture capital