This is a modified version of the report for Understanding Finance (Part 2: Sources of finance) in Bath Full Time MBA Class of 2020.

Sources of finance

Summary

This report will address three issues, one of which is to identify and explain three factors that a Chief Financial Officer (CFO) have consider to determine an appropriate source of finance for a company, which are mainly how much to pay dividends from retained earnings and the level of gearing with debt and equity. Another problem is to explain why debt is usually a cheaper source of finance than equity is true owing to tax deductibility and lower cost. The last topic is to describe the two sources of funding (revolving credit facility and senior note), explaining how each source of funding works and outlining at least one advantage and one disadvantage of each source.

Appropriate source of finance

The sources of finance for a company are mainly retained earnings, equity and debt. When a Chief Financial Officer (CFO) considers a harmony of these sources, they should think how much they should return the retained earnings as the dividends for their shareholders primarily. This is mainly because Assets of investors should be allocated by the most productive way, therefore, usually the retained earnings, consequently dividends ought to be reinvested to other more the companies or projects except for some cases including Google with zero dividend policy owing to having a great deal of cash generating projects internally. However, even if the company has some projects with a positive NPV, it may not be covered by only their retained earnings. In this situation, CFO should consider how to finance at the lowest cost, especially interest to gear with equity and debt, which are external sources for the company. There are two theories to find an optimal capital structure, which are pecking order theory and trade off theory, however, both argued that debt is better or more preferable than equity.

The reason debt is usually a cheaper source of finance than equity

why debt is usually a cheaper source of finance than equity can be mainly two reasons. One of them is that the cost of debt is less than the cost of equity due to lower risk. Although the issuer has to pay the arrangement fee when they issue the debt, still the cost is cheaper than the one of equity because they must pay the dividend unless they have no dividend policy. Another reason might be that the debt interest is tax deductible which lowers cost to the company.

The sources of funding (revolving credit facility and senior note)

The company is funded by debt mainly including revolving credit facility and senior note. A revolving credit (facility) is a modified line of credit which is a one-time agreement due to the fact that the account is closed when the company spends the maximum amount previously determined (Segal, 2019). However, the difference between a revolving credit and normal one is that the company can pay on a revolving credit account regularly with slightly higher interest rate which can be the one of major disadvantages. On the other hand, one of the major advantages might be that the company has the capability to pay on demand, which is equal to having the liquidity to pay by cash even if the company has no cash. The senior note is a debt to have a right to be paid by the issuer primarily when they are bankrupt in comparison with the subordinate debt (Watson and Head, 2019). The primary claim on an issuer’s assets and tax-deductible can be the major advantages. In contrast, one of the disadvantages might be that the issuer has to be redeemed when it reaches maturity. In addition, according to the tradeoff theory, the debt increases financial risk because the interest has to be paid primary and therefore the dividend may not remain. As a result, a senior note which has a higher interest than the normal one can increase the risk of bankruptcy more than using ordinary debt.

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