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Karnataka 1st PUC Business Studies Question Bank Chapter 8 Sources of Business Finance
1st PUC Business Studies Sources of Business Finance Text Book Questions and Answers
Multiple Choice Questions
Question 1.
Equity shareholders are called
(a) Owners of the company
(b) Partners of the company
(c) Executives of the company
(d) Guardian of the company
Answer:
(a) Owners of the company
Question 2.
The term ‘redeemable’ is used for
(a) Preference shares
(b) Commercial paper
(c) Equity shares
(d) Public deposits
Answer:
(b) Commercial paper
Question 3.
Funds required for purchasing current assets is an example of
(a) Fixed capital requirement
(b) Ploughing back of profits
(c) Working capital requirement
(d) Lease financing
Answer:
(c) Working capital requirement
Question 4.
ADRs are issued in
(a) Canada
(b) China
(c) India
(d) USA
Answer:
(d) USA
Question 5.
Public deposits are the deposits that are raised directly from
(a) The public
(b) the directors
(c) The auditors
(d) The owners
Answer:
(a) The public
Question 6.
Under the lease agreement, the lessee gets the right to
(a) Share profits earned by the lessor
(b) Participate in the management of the organisation
(c) Use the asset for a specified period
(d) Sell the assets
Answer:
(c) Use the asset for a specified period
Question 7.
Debentures represent
(a) Fixed capital of the company
(b) Permanent capital of the company
(c) Fluctuating capital of the company
(d) Loan capital of the company
Answer:
(d) Loan capital of the company
Question 8.
Under the factoring arrangement, the factor
(a) Produces and distributes the goods or services
(b) Makes the payment on behalf of the client
(c) Collects the client’s debt or account receivables
(d) Transfer the goods from one place to another
Answer:
(c) Collects the client’s debt or account receivables
Question 9.
The maturity period of a commercial paper usually ranges from
(a) 20 to 40 days
(b) 60 to 90 days
(c) 120 to 365 days
(d) 90 to 364 days
Answer:
(d) 90 to 364 days
Question 10.
Internal sources of capital are those that are
(a) generated through outsiders such as suppliers
(b) generated through loans from commercial banks
(c) generated through issue of shares
(d) generated within the business
Answer:
(d) generated within the business
Short Answer Questions
Question 1.
What is business finance? Why do businesses need funds? Explain.
Answer:
Financing is an important function of any business undertaking. It deals with the procurement of funds at the right time and their effective utilisation in business. The activities essential to successful administration of finance in any organisation comprise financial planning, raising the needed funds, judicial use of funds, financial analysis and control. Business finance involves not only the estimation of the amount of funds but also the sources of finance, investment of funds raised, management of cash, disposal of earnings etc.
Nature And Significance Of Business Finance:
Definition of Business Finance – According to B.O. Wheeler, “Finance is that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of a business enterprise.” In the words of Howard and Upton, “Business finance involves a set of administrative functions in an organisation which relates with the arrangement of cash and credit ‘ so that the organisation may have the means to carry out its objectives as satisfactorily as possible.”
Finance is a major function of any business. It deals, with the arrangement of adequate amount of capital to achieve the objectives of the enterprise. Only arrangement of capital is not sufficient. It is equally essential to utilise it in the best possible manner. The availability of finance determines the scale of production of business. It includes all types of capital or funds used in business.
Significance of Business Finance – Finance is the life blood of business. No business can carry on its operations smoothly and successfully without the finance. An important requirement for the success of a modern business is the provision of sufficient amount of capital.
No business undertaking can prosper unless it has got sufficient capital at its disposal to install up-to-date machines and equipment, buy raw materials, meet day-to-day expenses, pay wages and salaries, and so on. The importance of finance function has increased these days because of the adoption of capital intensive techniques, increase in the scale of operations and difficulties in raising finance.
There must be a continuous flow of funds in and out of business. Money makes the wheels of business run smoothly if it is managed efficiently. The success of a business depends, to a great extent on the manner in which it raises, employs and disburses its funds.
Business enterprises require capital for Hiree main purposes :
- financing fixed capital requirements, i. e., purchase of land and building, plant and machinery, furniture, etc.
- financing working capital requirements, i.e., purchase of raw materials, payment of wages and salaries, payment of freight, etc.
- financing growth and expansion programmes.
For providing sufficient capital to the business, several sources of finance have to be tapped. These include shareholders, debenture- holders, fixed depositors, banks and financial institutions.
If a firm is able to raise adequate finance, the following benefits will accrue to it:
- Business cycle from production to distribution of goods will run smoothly.
- The firm can install the latest plant and machinery.
- There will be no shortage of raw materials and other things.
- The firm can have an advantage in business opportunities. It can buy raw materials in bulk at economical prices.
- It can hold finished goods in stores to sell them at higher prices in the future.
- It can pay its creditors in time and enhance its market reputation.
Question 2.
List sources of raising long-term and short-term finance.
Answer:
Sources of Long Term Finance:
- Equity Shares
- Retained earnings
- Preference shares
- Debentures
- Loans from banks and other financial institutions.
Sources of Medium Term Finance:
- Lease financing
- Public deposits
- Loans grom banks and other financial institutions.
Sources of Short Term Finance:
- Trade credit
- Factoring
- Commercial papers.
- Short term loans from banks
Question 3.
What is the difference between internal and external sources of raising funds? Explain.
Answer:
Internal Sources of Finance:
- Internal sources of funds are those that are generated within the business.
- Examples of internal sources of finance are accelerating collection of receivables, disposing of surplus inventories and ploughing back of profit.
- The internal sources of funds can fulfill only limited needs of the business. Cost of internal funds is low.
- Business is not required to provide security while obtaining funds from internal sources.
External Sources of Finance:
- External sources of funds include those sources that he outside the organization, such as suppliers, lenders, and investors.
- Examples of external sources of finance are Issue of debentures, borrowing from commercial banks and financial institutions and accepting public deposits.
- Large amount of money can be raised through external sources. External funds are more costly.
- Business is required to mortgage its assets as security while obtaining funds from external sources.
Question 4.
What preferential rights are enjoyed by preference shareholders? Explain.
Answer:
Preference Shares: Preference shares are those shares which carry certain special or priority rights. Firstly, a dividend at a fixed rate is payable on these shares before any dividend is paid on equity shares. Secondly, at the time of winding up the company, capital is repaid to preference shares.
However, holders of preference shares may claim voting rights if the dividends are not paid for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares.
Preference shares have the characteristics of both equity shares and debentures. Like equity shares, dividend on preferences shares is payable only when there are profits and at the discretion of the Board of Directors. Preference shares are similar to debentures in the sense that the rate of dividend is fixed and preference shareholders do not generally enjoy voting rights. Therefore, preference shares are a hybrid form of financing.
Question 5.
Name any three special financial institutions and state their objectives.
Answer:
1. Industrial Finance Corporation of India (IFCI):
It was established in July 1948 as a statutory corporation under the Industrial Finance Corporation Act, 1948. Its objectives include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the development of management education in the country.
2. State Financial Corporation’s (SFCs):
State Financial Corporations are established by the State Governments under the Financial Corporations Act, 1951 for providing medium and short-term finance to industries which are outside the scope of the IFCI. Its scope is wider than IFCI as it covers not only public limited companies but also private limited companies, partnership firms, and proprietary concerns.
3. Life Insurance Corporation of India (LIC):
LIC was set up in 1956 under the LIC Act, 1956 after nationalizing 245 existing insurance companies. It mobilizes savings in the form of the insurance premium and makes it available to industrial concerns in the form of direct loans and underwriting of shares and subscriptions to shares and debentures.
Question 6.
What is the difference between GDR and ADR? Explain.
Answer:
International Sources of Finance – The euro issue is an international source of finance for Indian companies. Under such an issue, securities are issued in some foreign currency and are offered for sale internationally. That means private and corporate investors in different countries can purchase securities put for sale under a Euro issue by an Indian company. Before 1991, Indian companies were not allowed to raise finance from abroad. Therefore, the Indian financial system was insulated from the international financial markets.
With the advent of economic liberalisation and globalisation, Indian companies can tap international sources of finance for both debt and equity. Financial institutions and investors in foreign countries can invest in the shares and debentures of Indian companies.
There is an increasing trend towards tapping the global capital markets. Multinational companies are making substantial investments in India. The main instruments used by Indian companies to tap international sources of finance are given below:
Global Depository Receipts (GDRs) – A GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency. With the globalisation of capital markets, depository receipts expanded outside the US markets. Global Depository Receipts were introduced in 1990 at the initiative of Citibank. A GDR is similar to an ADR, except that it is placed in several markets simultaneously.
Global Depository Receipt (GDR) is a dollar-denominated instrument traded on a stock exchange in Europe or the US or both. It represents a certain number of underlying equity shares. Though the GDR is quoted and traded in dollar terms, the underlying equity shares are denominated in rupees. The shares are issued by the company to an intermediary called the depository in whose name the shares are registered.
It is the depository which subsequently issues the GDRs. The physical possession of the equity shares is with another intermediary called the custodian who is an agent of the depository. Thus, while a GDR represents the issuing company’s shares, it has a distinct identity and in fact, does not figure in the books of the issuer. GDR’s do not carry any voting rights unless they are converted into shares (in Indian rupees). However, dividend on GDR’s is to paid in rupees only as in case of equity shares.
The term global depository receipts indicate that the depository receipts are marketed globally rather than in any specific country or market. Companies with a good track record are allowed to issue GDRs for investing money in infrastructure projects including power, telecommunications, ports, roads, petroleum, etc.
A GDR means any instrument in a depository receipt or certificate issued by the Overseas Depository Bond outside India against shares or foreign currency bonds of any company. It is issued in the name of a foreign bank. Any overseas Depository Bank, situated outside India, may issue GDR’ to an overseas merchant bank which, in turn, will issue the same to non-resident’ investors.
A GDR is listed on Luxembourg or London Stock Exchanged. Any Indian company with good profit record can now raise funds from the international market by way of GDR. Reliance Industries Ltd. happens to be the first Indian company to raise funds through GDR. A custodian bank in Indian holds GDR, based on shares of any Indian company.
American Depository Receipts (ADRs) – An ADR is just like a GDR except that it can be issued to USA citizens only and can be listed and traded on a stock exchange of the USA. Thus, ADR’s are issued on behalf of an Indian Company for raising funds from the investors of the USA.
Like GDR’s ADR’s are also treated as Foreign Direct Investment (FDI) in the issuing company. An ADR is a negotiable instrument issued by an American Depository Bank certifying that shares of a non-US issuing company are held by the depository’s custodian bank.
The shares are issued by, say an Indian company, to a US intermediary called the depository in whose name the shares are registered. It is the depository which subsequently issues the ADRs. The physical possession of the equity shares is with another intermediary, the custodian, who is an agent of the depository.
An American Depository Receipt (ADR) is an American dollar-denominated instrument representing equity ownership in any non- American company. It represents the shares of any non-US company held on deposit by a custodian bank outside USA. Any American bank functioning as a depository can issue ADR which represents a specific number of shares of the issuing company outside USA. An ADR can be listed on New York Stock Exchange or any other stock exchange in USA.
It cap-be quoted on the NASDAQ (National Association of Securities Dealers Automated Quotation). It can also be privately placed id traded in USA. The dividend on ADRs is payable in the Indian currency i.e. rupee. That means there is no outflow of any foreign exchange. Like GDR, ADR can also be issued by the Ministry of Finance (Government of India) from time to time.
Long Answer Questions
Question 1.
Explain trade credit and bank credit as sources of short-term finance for business enterprises.
Answer:
Trade credit is the credit extended by one trader to another for the purchase of goods and services. It facilitates the purchase of supplies without immediate payment and is commonly used by business organizations as a source of short – term financing. Trade credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
It is granted prudently to those customers who have reasonable amount of financial standing and goodwill The volume and period of credit extended depends on factors such as reputation of the purchasing firm, financial position of the seller, volume of purchases, past record of payment and degree of competition in the market.
Terms of trad ecredit may vary from industry to industry and from person to person. As we know, trade is the purchase and sale of goods on profit motive. So, trade credit strictly refers to routine business activity. Bank Credit Commercial banks provide funds for different purposes and for different time periods to firms of all sizes by way of cash credits, overdrafts, term loans, purchase / discounting of bills, and issue of letter of credit.
The rate of interest charged by banks depends on various factors such as the characteristics of te firm and the level of interest rates in the economy. The loan is repaid either in lump sum or in installments. Bank credit is not a permanent sources of funds and is generally used for medium to short periods. The borrower is required to provide some security or create a change on the assets of the firm before a loan is sanctioned by a commercial bank.
Question 2.
Discuss the sources from which a large industrial enterprise can raise capital for financing modernization and expansion.
Answer:
Businesses should plan according to the time period for which the funds are required. For long-term finance, sources such as the issue of shares and debentures are more appropriate. Similarly, the purpose for which funds are required needs to be considered so that the source is matched with the use. For example, a long-term business expansion and modernazation plan should not be financed by a bank overdraft which will be required to be repaid in the short term.
Both Central and State Governments have established a number of financial institutions all over the country to provide industrial finance to industrial enterprises. They are called development banks such as Industrial Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), Unit Trust of India (UTI), Industrial
Investment Bank of India Ltd. This source of financing is considered suitable when large funds are required for expansion, reorganization, and modernization of the enterprise. With the liberalization and globalization of the economy, Indian companies have started generating funds from international markets.
The international sources from where the funds can be procured include foreign currency loans from commercial banks, financial assistance provided by international agencies and development banks, and the issue of financial instruments like GDR, ADRs, FCCB in international capital markets.
Question 3.
What advantages does the issue of debentures provide over the issue of equity shares?
Answer:
Debentures are long-term debt instruments which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a fixture date. Debenture holders are paid a fixed amount of interest at specified intervals say six months or one year.
Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of interest. Has also become popular in recent years. In the case of ZIDs, the difference between the face value of the debenture and its purchase price is the return to the investor.
Merits of Debentures over Equity Shares:
- Debentures are preferred by investors who want fixed income at lesser risk.
- Debentures are fixed charge funds and do not participate in the profits of the company.
- The issue of debentures is suitable in the situation when the sales and earnings are relatively stable.
- Financing through debentures does not dilute the control of shareholders on management as debentures do not carry voting rights.
- Financing through debentures is less costly as compared to the cost of equity capital as the interest payment on debentures is tax-deductible.
Question 4.
State the merits and demerits of public deposits and retained earnings as methods of business finance.
Answer:
Public Deposits – Public deposits that are raised directly by the organizations from the public are known as, public deposits. Public deposits refer to the unsecured deposits invited by companies from the public mainly to finance working capital needs.
A company wishing to invite public deposits makes an advertisement in the newspapers. Any member of the public can fill up the prescribed form and deposit the money with the company. The company in return issues a deposit receipt. This receipt is an acknowledgment of the debt by the company.
The terms and conditions of the deposit are printed on the back of the receipt. The rate of interest on public deposits depends on the period of deposit and the reputation of the company.
A company can invite public deposits for a period of six months to three years. Therefore, public deposits are primarily a source of short-term finance. However, the deposits can be renewed from time to time. Renewal facility enables companies to use public deposits as medium-term finance.
Public deposits of a company cannot exceed 25 percent of its share capital and free reserves. As these deposits are unsecured, the company having public deposits required to set aside 10 percent of deposits maturing by the end of the year The amount so set aside can be used only for paying such deposits. Kates of interest offered on public deposits are usually higher than those offered on bank deposits.
Public deposits can take care of both the medium and short-term financial requirements of a business. The deposits are beneficial to both the depositor as well as to the organization. While the depositors get a higher interest rate than that offered by banks, the cost of deposits to the company is less than those offered by banks.
Thus, public deposits refer to the deposits received by a company from the public as unsecured debt. Companies prefer public deposits because these deposits are cheaper than bank loans. The public prefers to deposit money with well-established companies because the rate of interest on public deposits is higher than on bank deposits. Now public sector companies also invite public deposits. Public deposits have become a popular source of industrial finance in India.
Merits of Public Deposits :
(1) Simplicity – Public deposits are a very convenient source of business finance. No cumbersome legal formalities are involved. The company raising deposits has to simply give an advertisement and issue a receipt to each depositor. The procedure of obtaining deposits is very simple and does not contain any restrictive conditions are laid down at the time of the loan agreement.
(2) Economy – Interest paid on public deposits is lower than that paid on debentures and bank loans Moreover, no underwriting commission, brokerage, etc. has to be paid. Interest paid on public deposits is tax-deductible which reduces tax liability. Therefore, public deposits are a cheaper source of finance. The cost of public deposits is generally much less than the cost of borrowing from banks and financial institutions.
(3) No charge on Assets – Public deposits are unsecured and, therefore, do not create any charge or mortgage on the company’s assets. The company can raise loans in the future against the security of its assets.
(4) Flexibility – Public deposits can be raised during the season to buy raw materials in bulk and for other short-term needs. They can be returned when the need is over. Therefore, public deposits introduce flexibility in the company’s financial structure.
(5) Trading on Equity – Interest on public deposits is paid at a fixed rate. This enables a company to declare higher rates of dividend to equity shareholders during periods of good earnings.
(6) No Dilution of Control – There is no dilution of shareholder’s control because the depositors have no voting rights.
(7) Wide Contacts – Public deposits enable a company to build up contacts with a wider public. These contacts prove helpful in the sale of shares and debentures in the future.
Demerits of Public Deposits :
(1) Uncertainty – Public deposits are an uncertain and unreliable source of finance. The depositors may not respond when economic conditions are uncertain. Moreover, they may withdraw their deposits whenever they feel shaky about the financial health of the company.
Now companies generally find is difficult to raise funds through public deposits. Depositors are entitled to withdraw their deposits at any time after giving prior notice to the company. During times of financial tightness or distress, the depositors may get panicky and wish to withdraw their deposits.
Moreover, if a large number of depositors simultaneously withdraw their deposits during a slump, the company may find it difficult to repay a huger sum at once. Therefore, public deposits are described as ‘fair-weather friends’.
(2) Limited Funds – A limited amount of funds can be raised through public deposits due to legal restrictions. It is an unreliable source of finance as the public may not respond when the company needs money:
(3) Temporary Finance-The maturity period of public deposits is short. The company cannot depend upon public deposits for meeting long-term financial needs. Collection of public deposits may prove difficult particularly when the size of deposits required is large.
(4) Speculation – As public deposits can be raised easily and quickly, a company may be tempted to raise more funds than it can profitably use. It may keep idle money to meet future contingencies. The management of the company may indulge in over-trading and speculation which exercise harmful effects on the business.
(5) Hindrance of Growth of Capital Market – Public deposits hamper the growth of a healthy capital market in the country. Widespread use of public deposits creates a shortage of industrial securities. Such deposits are known as ‘fair weather friends’. They may withdraw their money when they visualize the shaking position of the company even on false grounds.
(6) Limited Appeal – Public deposits do not appeal as a mode of investment to bold investors who want capital gains. Conservative investors may also not like these deposits in the absence of proper security. Investors think that money deposited by them may be used by the management in any way he lives.
(7) Unsuitable for New Concerns – New companies lacking in sound credit-standing cannot depend upon public deposits. Investors do not like to deposit money with such companies.
Retained Profits – A portion of net earnings may be retained in the business for use in the future. This is known as retained earning. Reinvestment of undistributed profits is a very good source of business finance. Retained profits refer to the profits which have not been distributed as dividends but have been kept for use in business. Profits are usually retained in the form of general reserves.
A part of the profits is transferred to the reserves every year. After a few years, it becomes a large amount which is then employed for modernisation, expansion, etc. of business. Retained profits are also known as ploughing back of profits, self-financing or internal financing. As the retained profits belong to the shareholders, they are considered ownership funds.
Advantages:
(1) Convenience – Retained profits are the most economical and convenient source of finance. No advertisement or prospectus has to be issued. No expenses or legal formalities are involved. No return is to be paid on retained earnings and no fixed obligations are created.
(2) No Charge on Assets – No charge or mortgage is created on the company’s assets. The company is free to use its assets for raising loans in the future.
(3) No Obligations – There is no fixed burden of dividend and no obligation of repayment. Retained profits are the company’s own money. It makes the company financially strong, increases its creditworthiness, and enables it to float new securities in the market and borrow from the public and financial institutions without any difficulty.
(4) No Interference – Retained profits involve no risk of control being diluted as there is no increase in the number of shareholders. Management remains independent as no restrictions are put on the management.
(5) Goodwill – Retained profits add to the financial strength, credibility, and earning capacity of the business. The company’s borrowing capacity is increased. It can safely face business cycles and other crises. Retained profits provide a cushion of security during adverse conditions. It is a good source of stabilizing the rate of dividend on equity shares.
(6) Dependable – As an internal source of finance retained profits are more dependable than external sources. The amount of funds is not dependent on investors’ preferences and market conditions.
(7) Growth and Expansion – Reinvestment of earnings increases capital formation which is necessary for the economic development of the country. Retained profits are very useful for financing new projects and the expansion of the business.
These are also necessary for innovations and the development of new products which are essential in industries like pharmaceuticals. Retained earnings enable the company to absorb the shocks due to economic depression and uncertainty in the capital markets.
Disadvantages :
(1) Low Dividends – Ploughing back of profits reduces the current rate of dividends. This may result in dissatisfaction among the shareholders as they do not get the expected rate of dividend.
(2) Speculation – It is the uncertain source of funds as the profits of the business are fluctuating. A company having large reserves may prompt its directors to indulge in speculation in the prices of its shares. The directors may change the dividend rate to create price changes in their favour.
Such price fluctuations may result in a loss for the shareholders. The directors may also misuse the funds for personal benefits. The management of the company may misuse the retained earnings by investing them in unprofitable areas or by spending them unnecessarily.
(3) Unbalanced Growth – Retained profits may interfere in the balanced industrial growth of the country. The profits which might have been invested in other industries are reinvested in the same industry. The opportunity cost associated with these funds is not recognized by many firms. This may lead to sub-optimal use of funds.
(4) Overcapitalisation – Too much ploughing back of profits may prompt management to issue bonus shares. Frequent capitalization of reserves may result in overcapitalization.
Question 5.
Discuss the financial instruments used in international financing.
Answer:
Various financial instruments used in international financing include:
1. Commercial Banks:
Commercial banks all over the world extend foreign currency loans for business purposes. They are an important source of financing non-trade international operations. The types of loans and services provided by banks vary from country to country. For example, Standard Chartered emerged as a major source of foreign currency loans to the Indian industry.
2. International Agencies and Development Banks:
A number of international agencies and development banks have emerged over the years to finance international trade and business. These bodies provide long and medium-term loans and grants to promote the development of economically backward areas in the world.
These bodies were set up by the Governments of developed countries of the world at national, regional, and international levels for funding various projects. The more notable among them include International Finance Corporation (IFC), EXIM Bank, and Asian Development Bank.
3. International Capital Markets:
Modem organisations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:
(a) Global Depository Receipts (GDR’s):
The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security.
In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange. A holder of GDR can at any time convert it into the number of shares it represents.
The holders of GDRs do not carry any voting rights but only dividends and capital appreciation. Many Indian companies such as Infosys, Reliance, Wipro, and ICICI have raised money through the issue of GDRs.
(b) American Depository Receipts (ADR’s):
The depository receipts issued by & company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks. It is similar to a GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of the USA.
(c) Foreign Currency Convertible Bonds (FCCB’s):
Foreign currency convertible bonds are equity-linked debt securities that are to be converted into equity or depository receipts after a specific period. Thus, a holder of FCCB has the option of either converting them into equity shares at a predetermined price or exchange rate or retaining the bonds.
The FCCB’s are issued in a foreign currency and carry a fixed interest rate which is lower than the rate of any other similar nonconvertible debt instrument. FCCB’s are listed and traded in foreign stock exchanges. FCCB ’s are very similar to the convertible debentures issued in India.
Question 6.
What is commercial paper? What are its advantages and limitations?
Answer:
The commercial paper emerged as a source of short-term finance in our country in the early nineties. Commercial paper is an unsecured promissory note issued by a firm to raise funds fora short period, ranging from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds, and banks.
As the debt is totally unsecured, the firms having good credit ratings can issue commercial papers. Its regulation comes under the preview of the Reserve Bank of India. The merits and limitations of a commercial paper are as follows :
Advantages/Merits:
- A commercial paper is sold on an unsecured basis and does not contain any restrictive conditions.
- As it is a freely transferable instrument, it has high liquidity.
- It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the: cost of commercial bank loans.
- A commercial provides a continuous source of funds. This is because their maturity can be tailored to suit the requirements of the issuing firm. Further, maturing commercial paper can be repaid by selling new commercial paper;
- Companies can park their excess funds in commercial paper thereby earning some good return on the same.
Limitations:
- Only financially sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method.
- The size of money that can be raised through the commercial paper is limited to the excess liquidity available with the suppliers of funds at a particular time.
- Commercial paper is an impersonal method of financing. As such if a firm is not in a position to redeem its paper due to financial difficulties, extending the maturing of a CP is not possible.
1st PUC Business Studies Sources of Business Finance Additional Questions and Answers
One Mark Questions
Question 1.
Mention any one source of Business Finance.
Answer:
Owners fund
Question 2.
Mention any one type of shares.
Answer:
Equity Share
Question 3.
Give one merit of Equity shares.
Answer:
Equity shares holders enjoy limited liability.
Question 4.
State any one type of preference shares.
Answer:
Cumulative preference shares.
Question 5.
State any one type of Debentures.
Answer:
Secured debentures.
Question 6.
Mention any one source of the owner’s fund.
Answer:
Equity Share.
Question 7.
Mention any one type of Financial Institutions.
Answer:
Industrial Finance Corporation of India.
Question 8.
Expand ADR.
Answer:
American Depository Receipts.
Question 9.
Expand GDR.
Answer:
Global Depository Receipts
Question 10.
Expand IDR.
Answer:
Indian Depository Receipts.
Question 11.
Expand ICD.
Answer:
Inter Corporate Deposit
Question 12.
Expand EXIM Bank.
Answer:
Export-Import bank
Two Marks Questions
Question 1.
What is business finance?
Answer:
Business finance is concerned with estimating, raising, allocating, and managing capital funds in meeting the financial needs of the business.
Question 2.
What do you mean by fixed capital?
Answer:
In order to start a business, funds are required to purchase fixed assets like land and building, plant and machinery, furniture and fixtures, etc., which is known as fixed capital.
Question 3.
Give the meaning of working capital.
Answer:
The financial requirement of a business enterprise does not end with the procurement of fixed assets, it needs funds for its day-to-day operations. This is known as working capital.
Question 4.
Define shares.
Answer:
The total capital of the company is divided into small units. Each unit is called a shares.
Question 5.
Give the meaning of ordinary shares.
Answer:
Ordinary shares are a type of shares that are not preferred and don’t pay any type of predetermined dividend amount.
Question 6.
Give the meaning of preference shares.
Answer:
Preference shares are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued.
Question 7.
Define debentures.
Answer:
A debenture is an instrument issued by the company acknowledging the debt raised from the general public.
Question 8.
Give the meaning of retained earnings.
Answer:
A portion of earning is retained in the business in form of the reserve for use in the future is called retained earnings.
Question 9.
Give the meaning of public deposit.
Answer:
Raising deposits by a company directly from the public for a specific period at a specific rate of interest is known as a public deposit.
Question 10.
What is discounting of the bill?
Answer:
The selling of bill to invoice discounting company before the due date of payment at a value which is less than the invoice amount.
Question 11.
What do you mean by trade credit?
Answer:
Trade credit is an agreement where a customer can purchase goods on account (without paying cash), paying the supplier at a later date.
Question 12.
What do you mean by Bearer debentures?
Answer:
The debentures which are payable to the bearer and whose names do not appear in the register of debenture holders are known as “Bearer Debentures”.
Five Marks Questions
Question 1.
What are the merits of Ordinary Shares?
Answer:
- Equity shares are suitable for investors who are willing to assume the risk for higher returns.
- Payment of dividends to the equity shareholders is not compulsory. Therefore, there is no burden on the company in this respect.
- Equity capital serves as permanent capital as it is to be repaid only at the time of liquidation of a company. As it stands last in the list of claims, it provides a cushion for creditors, in the event of winding up of a company.
- Equity capital provides creditworthiness to the company and confidence to prospective loan providers.
- Funds can be raised through equity issues without creating any charge on the assets of the company. The assets of a company are, therefore, free to be mortgaged for the purpose of borrowings, if the need be.
- Democratic control over the management of the company is assured due to the voting rights of equity shareholders.
Question 2.
What are the Demerits of Ordinary Shares?
Answer:
The major limitations of raising funds through the issue of equity shares are as follows:
- Investors who want steady income may not prefer equity shares as equity shares get fluctuating returns.
- The cost of equity shares is generally more as compared to the cost of raising funds through other sources.
- Issue of additional equity shares dilutes the voting power, and earnings of existing equity shareholders.
- More formalities and procedural delays are involved while raising funds through issue of equity share.
Question 3.
What do you mean by ADR, GDR, IDR?
Answer:
Modem organizations including multinational companies depend upon sizeable borrowings in rupees as well as in foreign currency. Prominent financial instruments used for this purpose are:
1. Global Depository Receipts (GDR’s):
The local currency shares of a company are delivered to the depository bank. The depository bank issues depository receipts against these shares. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR).
2. American Depository Receipts (ADR’s):
The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks. It is similar to a GDR except that it can be issued only to American citizens and can be fisted and traded on a stock exchange of USA.
3. An Indian Depository Receipt (IDR):
It is a financial instrument denominated in Indian Rupees in the form of a depository receipt created by a Domestic Depository (custodian of securities registered with the Securities and Exchange Board of India) against the under tying equity of issuing company to enable foreign companies to raise funds from the Indian securities Markets.
Question 4.
Briefly explain the Different Methods of Raising Finance.
Answer:
1. Equity Shares:
Equity shares are the most important source of raising long-term capital by a company. Equity shares represent the ownership of a company and thus the capital raised by the issue of such shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite to the creation of a company.
2. Preference Shares:
The capital raised by the issue of preference shares is called preference share capital. The preference shareholders enjoy a preferential position over equity shareholders in two ways:
- Receiving a fixed rate of dividend, out of the net profits of the company, before any dividend is declared for equity shareholders.
- Receiving their capital after the claims of the company’s creditors have been settled, at the time Of liquidation.
In other words, as compared to the equity shareholders, the preference shareholders have a preferential claim over dividend and repayment of capital. Preference shares resemble debentures as they bear a fixed rate of return.
3. Debentures:
These are important instruments for raising long-term debt capital. A company can raise funds through the issue of debentures, which bear- a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date. Debenture holders are, therefore, termed as creditors of the company. Debenture holders are paid a fixed stated amount of interest at specified
4. Commercial Banks:
Commercial banks occupy a vital position as they provide funds for different purposes as well as for different time periods. Banks extend loans to firms of all sizes and in many ways, like, cash credits, overdrafts, term loans, purchase/discounting of bills, and issue of letter of credit.
The rate of interest charged by banks depends on various factors such as the characteristics of the firm and the level of interest rates in the economy. The loan is repaid either in a lump sum or in installments.
5. Financial Institutions:
The government has established a number of financial institutions all over the country to provide finance to business organizations. These institutions are established by the central as well as state governments. They provide both owned capital and loan capital for long and medium-term requirements and supplement the traditional financial agencies like commercial banks. As these institutions aim at promoting the industrial development of a country, these are also called ‘development banks’.
6. Global Depository Receipt (GDR), and American Depository Receipt (ADR):
Every public company issues shares. These shares are listed and traded on various share markets. Companies in India issue shares which are traded on Indian share markets like BSE (Bombay Stock Exchange) and NSE (National Stock Exchange) etc.
Ten Marks Questions
Question 1.
What are the different types of Preference Shares?
Answer:
As the name indicates, these shares have certain privileges and preferential rights distinct from those attaching to equity shares. The shares which carry the following preferential rights are termed preference shares.
- A preferential right as to the payment of dividends during the lifetime of the company.
- A preferential right as to the return of capital in the event of winding up of the company.
Holders of these shares have a prior right to receive the fixed rate of dividends before any dividend is paid to equity shares. The rate of dividend is prescribed in the issue.
1. Cumulative preference shares:
Cumulative preference shares are those shares on which dividend goes on accumulating until it is fully paid. This means, if the dividend is not paid in one or more years due to inadequate profit, then such unpaid dividend gets accumulated. The accumulated dividend is paid when the company performs well.
The arrears of dividends are paid before making payment to equity shareholders. The preference shares are always cumulative unless otherwise stated in the Articles of Association. It means that if the dividend is not paid in any year or falls short of the prescribed rate, the unpaid amount is carried forward to next year and so on; until all arrears have been paid.
2. Non-cumulative preference shares:
Dividend on these shares does not accumulate. This means the dividend on shares can be paid only out of profits of that year. The right to claim dividends will lapse if the company does not make a profit in that particular year. If the dividend is not paid in any year, it is lost.
3. Participating preference shares:
The holders of these shares are entitled to participate in surplus profit besides preferential dividends. The surplus profit which remains after the dividend has been paid to equity shareholders up to a certain limit is distributed to preference shareholders.
4. Non-participating preference shares:
The preference shares are deemed to be non-participating if there is no clear provision in the Articles of Association. These shareholders are entitled only to a fixed rate of a dividend prescribed in the issue.
5. Convertible preference shares:
These shareholders have a right to convert their preference shares into equity shares. The conversion takes place within a certain fixed period.
6. Non-convertible preference shares:
These shares cannot be converted into equity shares.
7. Redeemable preference shares:
Shares that can be redeemed after a certain fixed period are called redeemable preference shares. A company limited by shares, if authorized by Articles of Association, issues redeemable preference shares. Such shares must be fully paid. These shares are redeemed out of divisible profit only or out of the fresh issue of shares made for this purpose.
8. Irredeemable preference shares:
Shares which are not redeemable i.e, payable only on the winding up of the company are called irredeemable preference shares. As per the Companies Act (Amendment made in 1988), the company cannot issue irredeemable preference shares.
Question 2.
What do you mean by Debentures and what are the types of Debentures.
Answer:
Debentures have occupied a significant position in the financial structure of the companies. It is one of the main sources of raising debt capital to meet long-term financial needs. Debentures represent borrowed capital. The debenture holders are creditors of the company. The debenture holder gets a fixed rate of interest as a return on his investment.
The Board of Directors has the power to issue debentures. The debentures can be of different kinds according to their terms of issue, conversion, provision of security, repayment, etc. Let us discuss them in detail.
1. Secured debentures:
The debentures can be secured. The property of the company may be charged as security for the loan. The security may be for some particular asset (fixed charge) or it may be the asset in general (floating charge). The debentures are secured through ‘Trust Deed’.
2. Unsecured debentures:
These are the debentures that have no security. The issue of unsecured debenture is now prohibited by the Companies (Amendment) Act, 2000.
3. Registered debentures:
Registered debentures are those on which the name of holders are recorded. A company maintains a register of debenture holders in which the names, addresses, and particulars of holdings of debenture holders are entered. The transfer of debentures, in this case, requires the execution of a regular transfer deed.
4. Bearer debenture:
The name of the holders is not recorded on the bearer debentures. Their names do not appear on the register of debenture holders. Such debentures are transferable by mere delivery. Payment of interest is made by means of coupons attached to the debenture certificate.
5. Redeemable debentures:
Debentures are mostly redeemable i.e. payable at the end of some fixed period, as mentioned on the debenture certificate. Repayment can be made at a fixed date at the end of a specific period or by installments during the lifetime of the company. The provision of repayment is normally made ina trust deed.
6. Irredeemable debentures:
These kinds of debentures are not repayable during the lifetime of the company. They are repayable only after the liquidation of the company or when there is a breach of any condition or when some contingency arises.
7. Convertible debentures:
Convertible debentures give the right to the holder to convert them into equity shares after a specific period. Such right is mentioned in the debenture certificate. The issue of convertible debenture must be approved by a special” resolution in a general meeting before they are issued to the public.
8. Nonconvertible debentures:
Non-convertible debentures are not convertible into equity shares on maturity. These debentures are normally redeemed on the maturity date. These debentures suffer from the disadvantage that there is no appreciation in value.
Question 3.
What are the Merits and Demerits of Equity Shares?
Answer:
Advantages of the company: The advantages of issuing equity shares may be summarized as below:
- Long-term and Permanent Capital: It is a good source of long-term finance. A company is a riot required to pay-back the equity capital during its life-time and so, it is a permanent source of capital.
- No Fixed Burden: Unlike preference shares, equity shares suppose no fixed burden on the company’s resources, because the dividend on these shares is subject to the availability of profits and the intention of the board of directors. They may not get the dividend even when a company has profits. Thus they provide a cushion of safety against unfavorable development
- Creditworthiness: Issuance of equity share capital creates no change on the assets of the company. A company can raise further finance on the security of its fixed assets.
- Risk Capital: Equity capital is said to be the risk capital. A company can trade on-equity in bad periods on the risk of equity capital.
- Dividend Policy: A company may follow an elastic and rational dividend policy and may create huge reserves for its developmental programmes.
Advantages to Investors: Investors or equity shareholders may enjoy the following advantages:
- Mare Income: Equity shareholders are the residual claimant of the profits after meeting all the fixed commitments. The company may add to the profits by trading on equity. Thus equity capital may get dividends at high in a boom period.
- Right to Participate m the Control and Management: Equity shareholders have voting rights and elect competent persons as directors to control and manage the affairs of the company.
- Capital profits: The market value of equity shares fluctuates directly with the profits of the company and their real value based on the net worth of the assets of the company. An appreciation in the net worth of the company’s assets will increase the market value of equity shares. It brings capital appreciation in their investments.
- An Attraction of Persons having Limited Income: Equity shares are mostly of lower denomination and persons of limited recourses can purchase these shares.
- Other Advantages: It appeals most to the speculators. Their prices in the security market are more fluctuating.
Disadvantages of equity shares:
Disadvantages to the company: Equity shares have the following disadvantages to the company:
- Dilution in control: Each sale of equity shares dilutes the voting power of the existing equity shareholders and extends the voting or controlling power to the new shareholders. Equity shares are transferable and may bring about the centralization of power in few hands. Certain groups of equity shareholders may manipulate control and management of the company
- Trading on equity not possible: If equity shares alone are issued, the company cannot trade on equity.
- Over-capitalization: Excessive issue of equity shares may result in overcapitalization. The dividend per share is low in that condition which adversely affects the psychology of the investors. It is difficult to cure.
- No flexibility in capital structure: Equity shares cannot be paid back during the lifetime of the company. This characteristic creates inflexibility in the capital structure of the company.
- High cost: It costs more to finance with equity shares than with other securities as the selling costs and underwriting commission are paid at a higher rate on the issue of these shares.
- Speculation: Equity shares of good companies are subject to hectic speculation in the stock market. Their prices fluctuate frequently which is not in the interest of the company.
Disadvantages to investors: Equity shares have the following disadvantages to the investors:
- Uncertain and Irregular Income: The dividend on equity shares is subject to the availability of profits and the intention of the Board of Directors and hence the income is quite irregular and uncertain. They may get no dividend even three are sufficient profits.
- Capital loss During Depression Period: During a recession or depression periods, the profits of the company come down and consequently the rate of dividend also comes down. Due to the low rate of dividend and certain other factors, the market value of equity shares goes down resulting in a capital loss to the investors.
- Loss on Liquidation: In case, the company goes into liquidation, equity shareholders are the worst suffers. They are paid in the last only if any surplus is available after every other claim including the claim of preference shareholders is settled.