Module 5 Sources of Funds PDF

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BUSINESS FINANCEFor Senior High School12Learning Module for Senior High School – Business FinanceBusiness Finance – Grade 12 Alternative Delivery Mode Quarter 3 – Module 1: First Edition, 2020Republic Act 8293, section 176 states that: No copyright shall subsist in any work of the Government of the ...

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12 BUSINESS FINANCE For Senior High School

GRADE 12 Learning Module for Senior High School – Business Finance Business Finance – Grade 12 Alternative Delivery Mode Quarter 3 – Module 1: First Edition, 2020 Republic Act 8293, section 176 states that: No copyright shall subsist in any work of the Government of the Philippines. However, prior approval of the government agency or office wherein the work is created shall be necessary for exploitation of such work for profit. Such agency or office may, among other things, impose as a condition the payment of royalties. Borrowed materials (i.e., songs, stories, poems, pictures, photos, brand names, trademarks, etc.) included in this module are owned by their respective copyright holders. Every effort has been exerted to locate and seek permission to use these materials from their respective copyright owners. The publisher and authors do not represent nor claim ownership over them. Published by the Department of Education Secretary: Leonor Magtolis Briones Undersecretary: Diosdado M. San Antonio Development Team of the Module Writer: Reviewers/Validators: Illustrator: Writer Layout Artist: Writer Management Team :

Printed in the Philippines by ________________________ Department of Education – National Capital Region Office Address:

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GRADE 12 Learning Module for Senior High School – Business Finance

12 BUSINESS FINANCE Quarter 3: Module __

The Sources and Uses of Shortterm and Long-term Funds

Grade 12 Learning Module for Senior High School – Business Finance

Introductory Message For the facilitator: Welcome to the Business Finance Alternative Delivery Mode (ADM) Module on Uses of Short-term and Long-term Funds

The Sources and

This module was collaboratively designed, developed and reviewed by educators both from public and private institutions to assist you, the teacher or facilitator in helping the learners meet the standards set by the K to 12 Curriculum while overcoming their personal, social, and economic constraints in schooling. This learning resource hopes to engage the learners into guided and independent learning activities at their own pace and time. Furthermore, this also aims to help learners acquire the needed 21st century skills while taking into consideration their needs and circumstances. In addition to the material in the main text, you will also see this box in the body of the module:

Notes to the Teacher This contains helpful tips or strategies that will help you in guiding the learners.

As a facilitator you are expected to orient the learners on how to use this module. You also need to keep track of the learners' progress while allowing them to manage their own learning. Furthermore, you are expected to encourage and assist the learners as they do the tasks included in the module. For the learner: Welcome to Business Finnace Alternative Delivery Mode (ADM) Module on The Sources and Uses of Short-term and Long-term Funds

The hands is one of the most symbolized part of the human body. It is often used to depict skill, action and purpose. Through our hands we may learn, create and accomplish. Hence, the hand in this learning resource signifies that you as a learner is capable and empowered to successfully achieve the relevant competencies and skills at your own pace and time. Your academic success lies in your own hands! This module was designed to provide you with fun and meaningful opportunities for guided and independent learning at your own pace and time. You will be enabled to process the contents of the learning resource while being an active learner.

Grade 12 Learning Module for Senior High School – Business Finance

This module has the following parts and corresponding icons: What I Need to Know

This will give you an idea of the skills or competencies you are expected to learn in the module.

What I Know

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Grade 12 Learning Module for Senior High School – Business Finance

The following are some reminders in using this module:

1. Use the module with care. Do not put unnecessary mark/s on any part of the module. Use a separate sheet of paper in answering the exercises. 2. Don’t forget to answer What I Know before moving on to the other activities included in the module. 3. Read the instructions carefully before doing each task. 4. Observe honesty and integrity in doing the tasks and checking your answers. 5. Finish the task at hand before proceeding to the next. 6. Return this module to your teacher/facilitator once you are through with it. If you encounter any difficulty in answering the tasks in this module, do not hesitate to consult your teacher or facilitator. Always bear in mind that you are not alone. We hope that through this material, you will experience meaningful learning and gain deep understanding of the relevant competencies. You can do it!

What I Need to Know As we study and immerse ourselves in “Business Finance” in the process, it is necessary to know some the sources and uses of short-term and long term funds. Most Essential Learning Competency: After going through this module, you are expected to achieve: 1. Understanding on sources and uses of 1.1 1.2

Short term funds Long term funds;

2. Comparison and Contrast on the loan requirements of different banks and non-bank institutions.

Grade 12 Learning Module for Senior High School – Business Finance

Lesson 3

The Sources and Uses of Short-term and Long-term Funds

What’s New

SHORT-TERM SOURCES OF FINANCING

Short-term financial management also known as capital management involve cash inflows and outflows that occur within a year or less. Short term funds are defined as those that are due and payable within a year. Factors in Selecting Source of Short-term Funds In general, the basic factors to be considered in selecting among alternative shortterm financing opportunities are; 1. the affective cost of credit 2. the availability of credit in the amount needed and for the period of time when financing is required, 3. the influence of the use of particular credit source on the cost and availability of other sources of financing, and 4. any additional covenants of the loans that are unique. Sources of Short-term Funds Short-term funds can be obtained through either unsecured credit or secured loans. Unsecured credit include all those sources that have as their security is the the lender’s faith and its ability as borrower to repay the funds when due. The major sources of unsecured short-term credit are; 1. Accruals 2. Trade Credit 3. Bank Loans 4. Commercial Papers The principal suppliers of unsecured credit includes (1) commercial banks, (2) finance companies, and (3) suppliers. Secured loans involve the pledge of specific assets as collateral in the event the borrower defaults in payment of principal or interest. The primary sources of collateral include account receivables, marketable securities and invenories.

Grade 12 Learning Module for Senior High School – Business Finance

Unsecured Short-Term Financing Accruals As the firm’s sales increase, so do its salaries and wage expense, value-added taxes, income taxes, and so on. Since most of the businesses pay their employees only periodically (weekly, biweekly, or monthly) they acrrue a wages payable account, that is, a loan from firm’s employees. Income taxes are likewise paid quarterly, VAT, withholding taxes, electricity, and other expenses are paid on a deferred basis. The longer the period of time that the firm holds these payments, the greater the amount of financing they provide. Trade Credit Tax credit provides one of the most flexible sources of financing available to the firm. It is also a primary source of spotaneous financing because it arises from ordinary business transactions. If the firm chooses to forego a possible cash discount opportunity and utilize the funds made available to finance its working capital, then the resulting cash, as an annualized percent, can be high indeed. For example, if the seller offers terms of 2/1, n/3 which means a 2% discount from the purchase price if paid in 1 days, the the buyer incurs an opportunity cost of 36.7% per year if the discount is not taken. This is computed using

Approximate Discount rate 36 Effetive cost of Credit = 1 - Discount rate x Credit period – Discount period 2% 36 = 1% - 2% x 3 - 1 = 36.7%

Short-Term Bank Loans Commercial banks are second in importance to trade credit as a source of shortterm financing. Banks provide nonspontenous funds. As a firms financing needs increase, it requires additional funds from the bank. Short-term loans vary in type, availability and cost. The most common type is the commercial bank loan that is for a specific purpose, short-term and self-liquidating. Cash flow forecast showing repayment ability are of prime importance. Detailed financial statements maybe required before the loan is granted. When a bank loan is approved, the agreement is executed by signing a promissory note. The note specifies the 1. Amount borrowed 2. Percentage interest rate 3. Repayment schedule 4. Any collateral that might have to be put as security for the loan, and 5. Any other terms and conditions to which the bank and the borrower may have agreed.

Grade 12 Learning Module for Senior High School – Business Finance

Commercial Paper Commercial paper is an unsecured short term (six months or less) promissory note sold in the money market by highly credit-worthy firms. Approval of the Securities and Exchange Commision is necessary before such promissory notes can be issued. Big firms use commercial paper to finance their working capital because it is much expensive than the cost of trade credit. In addition, commercial paper cost are lower than most bank loans and are not subject to possibly restrictive covenants contained in many banks. Some potential disadvantage of commercial paper relative to trade credit are 1. the fix maturity date which raises the liquidity risk, and 2. its lack of user availability except for very large firms. Secured Short-Term Financing Secured sources of short-term credit have certain assets of the firm pledge as collateral to secure the loan. Upon default of the loan agreement, the lender has the first claim of the pledge assets in addition to its claims as a general creditor of the firm. Hence, the secured credit agreement offers an added margin of safety to the lender. Secured short-term financing are obtainable through; 1. Pledging of accounts receivable 2. Factoring of accounts receivable 3. Inventory loans

LONG-TERM SOURCES OF FINANCING

Long-term investment or capital expenditures are important to they often require substantial outlays that affect the firm’s direction. The benefits to the company are expected to extend Sound capital investment decision can lead to higher earnings, firm achieve its goal of maximizing the owner(s)’ wealth.

the firm because profitability and beyond one year. thus, helping the

Long term investments may involve a. Expansion projects to increase existing capacity or to make new products or to enter new markets b. Replacement projects to replace worn-out or obsolete facilities or equipment with new ones c. Modernization projects to upgrade or to improve existing machinery and other fixed assets d. Safety or environmental projects to meet the requirements of government, labor unions or insurance companies e. Expenditures for advertising campaign f. A research and development program g. Employee education and training

Grade 12 Learning Module for Senior High School – Business Finance

Long-term sources of funds are availed of to finance the capital expenditures of the firm. Some of the capital used to finance assets come from equity financing (ownership shares in the firm) debt financing (borrowed funds, usually loans and bonds) and retained earnings (profits that firms retains and reinvest).

Debt Financing Debt financing is borrowing of money in order to acquire an asset, it includes loans from friends and relatives as well as external capital ( loans from banks or venture capitalist). Almost all new and small business owners must borrow from external sources. Advantages and Disadvantages of Debt Financing The financial manager must consider weather debt will contribute or detract from firm’s operations. The advantages of debt are; 1. Tax deductibility of interest 2. Specific and fixed obligation 3. Benefit during inflationary period 4. Lower cost of capital On the other hand, the disadvantages are; 1. Mandatory obligation to pay the lender regardless of economic conditions 2. Restrictive covenants or conditions 3. Leverage could depress value of equity Equity Financing Equity financing involves raising of funds through the sale of equity shares in a corporation or additional funds infused in the business by the owner or partners in a sole proprietorship and partnership, respectively. Advantages and Disadvantages of Equity Financing The advantages of equity share stem from placing minimum contratints on the firm and include; 1. No mandatory fixed charges 2. No definite maturity date 3. Potentially greater ease of sale 4. Increased creditworthiness 5. Avoidance of restrictive provisions Some significant disadvantages of issuing ordinary share are; 1. Dilution of control and earnings 2. Higher issue cost 3. Causes increase in component cost of capital

Grade 12 Learning Module for Senior High School – Business Finance

Comparison between Debt / Equity Financing The following table presents the brief comparison between debt /equity financing Debt 1. Capital is repayable to the lender

Equity 1. Capital is generally not to be returned to the owner(s) 2. Interest is mandatory 2. Dividends are not compulsory 3. Interest is tax deductible 3. Dividends are not tax deductible 4. Financial risk is increased 4. No increase in financial risk 5. Increases in profitability if leverage is 5. No increase in profitability if the firm positive is in financial distress 6. Restrictive covenants or conditions 6. No restrictive covenants 7. No dilution or decrease in control 7. New issue may lead to dilution of unless terms of restrictive covenants are control and income of current owner(s) broken 8. Cheaper issuance cost 8. Higher issuance cost 9. Often easier to financial institutions 9. More complex right issues or new issue 1. Possible adverse effect on credit 1. No adverse effect on credit rating rating

Common Sources of Long-Term Debt Financing 1. Term Loans A term loan is a contract under which a borrower agrees to make a series of interest and principal payments of specific dates to the lender. 2. Bonds A bond is any given long-term promissiory note issued by the firm. A bond certificate is the tangible evidence of debt issued by a corporation or governmental body and represents a loan made by investors to the issuer. Trading Process for Corporate Bonds The initial or primary sale of corporate bond issue occurs either through a public offering, using an investment bank serving as security underwriter or through a private placement to small group of investors. Generally, when a firm issues bonds to the public, many investment banks are interested in enderwriting the bonds. The bonds can generally be sold in national market. Sell Bonds

Corporation

Sell Bonds Underwriter

Investors

(Investment Bank)

Pays Bid Price

Pays Offer Price

Figure 1.1 Firm Commitment Underwriting of Corporate Bond Issue

Grade 12 Learning Module for Senior High School – Business Finance

3. Leasing Leasing provides an alternative to buying an asset in order to acquire its services. The lease financing is considered a source of intermediate term credit There are three major types of lease agreements, namely a. direct lease b. sale and leaseback c. leverage leasing Direct leasing. The lease agreements involves the lessor purchasing the asset and leasing it to the lessee. This is available through the number of financial institutions including banks, finance companies, independent leasing companies and special purpose leasing companies. Sale and leaseback. This arrangement arises when a firm sells land, buildings, or equipment that it already owns to a lessor and simultaneously enters into an agreement to lease the property back for a secified period under specific terms. Leveraged leasing. In this arrangement, in addition to the lessor and lessee, a third party, the lender who helps finance the acquisition of the asset to be leased comes into the picture. Common Sources of Equity Financing 1. Ordinary Shares The major equity sources of capital for long-term investment in the firm come from ordinary shares and retained earnings. Ordinary share brings with it the right to share in the profits as well as losses of the business. Being the ultimate owners of the corporation, the ordinary shareholders control all profits of the firm after the preferred stockholders have been paid. 2. Prefered Shares Preferred shares lies between debt and common equity. It is considered hybrid source of financing because it is similar to bonds in some respects and to common stock in others. Like bonds, preferred stock has a par value and a fixed amount of dividends which must be paid before dividends can be paid on common stock. Like common stocks, preferred stock do not have maturity dates and never needed to be paid off. Preferred stocks do not generally have voting rights but have a higher priority claim than the common stockholders.

Grade 12 Learning Module for Senior High School – Business Finance

What is it Comparative Features of Ordinary Equity Shares, Preferred Shares, and Debt The characteristics of ordinary shares, preferred shares and bonds are compared in the following table.

a. Ownership and control of the firm

b. Ob...