Sources of Funds for

Private Sector
Money Generated from the Operation
of the Firm

 A major source of capital investment money is through the retention of

profits resulting from the operation of the firm. Since only about half of the
profits of industrial firms are paid out to stockholders, the half that is
retained is an important source of funds for all purposes, including capital
investments.
 In addition to profit, there is money generated in the business equal to the
annual depreciation charges on existing capital assets if the firm is
profitable. In other words, a profitable firm will generate money equal to its
depreciation Charges plus its retained profits. Even a firm that earns zero
profit will still generate money from operations equal to its depreciation
charges
External Sources of Money

 When a firm requires money for a few weeks or months, it typically borrows from banks.
 Longer-term unsecured loans (of, say, 1-4 years) may also be arranged through banks.
 While banks undoubtedly finance a lot of capital expenditures,regular bank loans cannot
 be considered a source of permanent financing.
 Longer-termsecuredloansmaybe obtainedfrom banks,insurance companies,pension
 funds, or even the public. The security for the loan is frequently a mortgage on specific
 property of the firm.When sold to the public, this financingis by mortgage bonds. The sale
 of stock in the firm is still another source of money.While bank loans and bonds represent
 debt that has a maturity date, stock is considered a permanent addition to the
ownershipof
 the firm.
Cost of Borrowed Money

 interest rate at which money can be borrowed. Longer-terms ecured loans may be
obtained
 from banks, insurance companies,or the variety of places in which substantial amounts of
 money accumulates (for example, the oil-producing nations).
 A large, profitable corporation might be able to borrow money at the prime rate, that
 is, the interest rate that banks charge their best and most sought-after customers. All other
 firms are charged an interest rate that is higher by one-half to several percentage points.
 In addition to the financial strength of the borrower and his ability to repay the loan, the
 interest rate will vary depending on the duration of the loan.
Characteristics of Equity (Raising
Money by selling shares of Firm)

 Equity investors put funding into a business or project seeking financial returns by
taking an ownership stake in the investment entities
 Investment entity will:
 –i) pay a percentage of future profits/dividends back to the investor,
 –ii) appreciate in value over the cost basis until the investor’s planned exit
 Equity ownership may also be assigned to implementing partners or managers that
contribute “sweat equity” or contributed assets
 Investors are motivated by the higher rates of return from the “upside exposure” to
the investment’s success through sharing in future annual profit
 Equity investor takes the most risk due to being “junior” to loan providers in the
capital structure
 May have management step-in rights
Characteristics of Loans
(commercially oriented)

 Lenders provide capital in return for a pre-agreed interest rate, usually

paid routinely over the period of the loan
 Lenders are motivated by investments with a known stream cash flows to
pay interest and minimizing the risk of principal repayment
 Exposure of a loan is less risky than an equity investor’s position given the
fixed interest repayments and the loan ranking ahead of equity capital for
repayment
 Tranches of loans may be “senior”, “junior” and “mezzanine” that
describe the priority of repayment
How is debt 'a relatively cheaper form
of finance than equity'?

 For example, if you run a small business and need $40,000 of financing, you
can either take out a $40,000 bank loan at a 10 percent interest rate or you
can sell a 25 percent stake in your business to your neighbor for $40,000.
 Suppose your business earns a $20,000 profit during the next year. If you took
the bank loan, your interest expense (cost of debt financing) would be $4,000,
leaving you with $16,000 in profit.
 Conversely, had you used equity financing, you would have zero debt (and as
a result, no interest expense), but would keep only 75 percent of your profit (the
other 25 percent being owned by your neighbor). Therefor, your personal profit
would only be $15,000, or (75% x $20,000).

Tax benefit: The firm gets an income tax benefit on the interest component
that is paid to the lender. Dividends to equity holders are not tax deductable.
 There is limited risk for the lender, but high risk for the borrower. This is
because the debt needs to be serviced i.e. principal and interest
repayments need to be made, irrespective of whether the firm is making a
profit or a loss or general economic conditions. Firms with large debt
balances during the economic crisis, felt tremendous pressure.
 Taking on debt can be beneficial till a certain point. But when the
company becomes over-leveraged, the cost of raising additional debt
becomes more and more expensive. This is because the earlier lenders
would have laid the first claim on the company's assets. The subsequent
lenders will thus charge more interest as the lending becomes riskier. Credit
ratings also deteriorate as more and more debt capital is raised.