Class 11 Business Studies Chapter 8 Source of Business Finance

Key Concept: Purpose of Finance

b) To purchase fixed assets and run day-to-day operations

[Solution Description] Businesses need finance primarily to purchase fixed assets necessary for their operations, as well as to ensure smooth day-to-day functioning by covering working capital requirements.

Key Concept: Basic Definition

a) Financial instruments representing local shares

[Solution Description]

ADRs are financial instruments issued by a U.S. bank that represent shares in a foreign company and allow that company’s stock to be traded on U.S. stock exchanges.

Key Concept: Basic Agencies

c) International Finance Corporation (IFC)

[Solution Description] According to the syllabus, notable development banks include International Finance Corporation (IFC), EXIM Bank, and Asian Development Bank.

Key Concept: Depository Receipts

c) They are denominated in US dollars

[Solution Description] GDRs are negotiable financial instruments that represent shares in a foreign company, and they are denominated in US dollars. This makes them accessible to international investors.

Key Concept: Comparison of Capital Types

c) Working capital

[Solution Description] Working capital is used for day-to-day operational expenses such as paying for utilities, salaries, and purchasing raw materials.

Key Concept: Time Period Classification

b) Trade credit

[Solution Description] Short-term sources of finance are defined as funding options available for a period not exceeding 1 year. Trade credit is one such example that falls under this category.

Key Concept: Simple Comparison

d) Trade credit

[Solution Description] Trade credit usually involves lower procurement costs compared to other financing options such as bank loans or equity shares because it often does not involve interest.

Key Concept: Lease Purpose

b) Technological obsolescence

[Solution Description] Lease financing is often employed for assets that are susceptible to technological obsolescence because it allows companies to modernize their equipment without incurring high upfront costs.

Key Concept: Merits of Factoring

c) It accelerates cash flow, allowing the client to meet liabilities promptly

[Solution Description] One of the key merits of factoring is that it accelerates cash flow by converting accounts receivable into immediate cash. This allows the client to meet liabilities promptly without waiting for the payment terms of the invoices to be fulfilled.

Key Concept: Definition Focus

c) Bonds issued in foreign currency with an option to convert into equity

[Solution Description] FCCBs are a type of convertible bond issued in foreign currency, allowing the holder to convert them into equity shares or depository receipts after a specified period.

Key Concept: Regulatory Body

b) RBI

[Solution Description] The Reserve Bank of India (RBI) is the regulatory body responsible for overseeing and regulating the acceptance of public deposits by companies in order to protect depositor interests.

Key Concept: Share Dilution, Preference Share Limitations

a) The dividends of preference shareholders will increase only if they have participating rights.

[Solution Description] Issuing additional equity shares can dilute the ownership and dividend of existing equity shareholders but does not directly affect preference shareholders since their dividends are fixed unless they hold participating preference shares. In case of participating preference shares, they could receive additional dividends if there is surplus profit after paying equity shareholders, assuming such terms exist in the issuing agreement.

Key Concept: Basic Concept Understanding

c) Lease financing

[Solution Description] Lease agreements do not appear as liabilities on a company’s balance sheet and thus do not impact its ability to raise additional debt.

Key Concept: Merits Identification

c) CP provides high liquidity and lower cost than bank loans.

[Solution Description] Commercial Paper offers several advantages for issuers, including being an unsecured instrument, which means it doesn’t require collateral. It provides high liquidity, as it can be easily converted into cash before maturity due to active trading in the secondary market. Additionally, CP generally has a lower cost compared to bank loans because it typically carries lower interest rates. This makes CP an attractive option for companies looking to manage costs effectively.

Key Concept: Flexibility and Ease

b) Bank overdraft

[Solution Description] Short-term loans or credit lines are usually flexible and quickly accessible options for businesses needing immediate funds.

Key Concept: Risk Evaluation

d) Trade credit

[Solution Description] Trade credit typically involves the least risk as it does not require any immediate payment or interest, compared to loans or equity which may involve significant financial obligations.

Key Concept: Risk and Cost

c) Borrowed funds

[Solution Description] Borrowed funds, such as loans from banks, involve interest payments which can vary with market conditions, leading to higher risk related to cost variability. Over time, interest expenses contribute to a higher cost compared to owner’s funds.

Key Concept: Impact Assessment, Long-term Planning

b) Decrease fixed capital investments to retain liquidity

[Solution Description] During anticipated economic recessions, enterprises should ideally reassess their fixed capital investments. Reducing or deferring such investments can conserve cash reserves, maintaining liquidity amidst unpredictable market conditions. Instead, focusing on operational efficiency and cost management without expanding fixed asset commitments helps withstand economic downturns.

Key Concept: Shareholder Satisfaction

c) They receive lower dividends

[Solution Description] Excessively retaining earnings means not distributing enough dividends to shareholders, which can lead to lower dividend income for them. Shareholders often prefer receiving returns on their investment in the form of dividends.

Key Concept: Source Suitability

b) Public deposits

[Solution Description] Medium-term sources are suitable for financing needs between 1 to 5 years. Public deposits, lease financing, and loans from financial institutions fall under this category.

Key Concept: Control Implications

b) Dilutes their earnings.

[Solution Description] Issuing additional equity shares can dilute the voting power and earnings per share of existing shareholders as the total number of shares increases, thereby reducing their individual stake.

Key Concept: Dividend Policy Impact

c) Higher dividends decrease retained earnings

[Solution Description] Retained earnings are affected by the company’s dividend policy since it determines how much of the net profit is distributed to shareholders as dividends and how much is retained within the company. If a company decides to distribute higher dividends, less profit will be available to be added to retained earnings.

Key Concept: Basic Definition

c) To acquire and manage funds necessary for business operations

[Solution Description]

Business finance is essential for acquiring funds needed to start and run a business successfully. It involves managing money efficiently to achieve the business goals.

Key Concept: Basic Concept Understanding

c) Fixed capital

[Solution Description] Fixed capital is used for purchasing fixed assets such as machinery and buildings, which are necessary for the production process and other business functions.

Key Concept: Internal vs External

b) Bank loan

[Solution Description] External sources of capital are those that are generated outside the company, such as bank loans or issuance of debentures.

Key Concept: Control and Ownership

c) It decreases existing shareholders’ control

[Solution Description] Issuing new equity shares usually dilutes the ownership percentage of the existing shareholders unless they participate in the new issuance. This can lead to reduced control over company decisions due to voting rights being spread among more shareholders.

Key Concept: Basic Definition

b) A negotiable instrument representing company’s local currency shares, issued by a depository bank.

[Solution Description] A Global Depository Receipt (GDR) is a negotiable financial instrument issued by a depository bank. It represents shares in a foreign company and is traded on international stock exchanges.

Key Concept: Flexibility of Loans

b) Flexible loan amounts

[Solution Description] Commercial bank loans offer flexibility in loan amounts, allowing borrowers to adjust the amount as needed according to changes in their business requirements.

Key Concept: Basic Concepts

c) Facilitating sufficient funding for operations and growth

[Solution Description] The primary role of business finance is to ensure that there are adequate funds available for the organization’s operations and expansion plans. It involves managing resources efficiently to achieve company goals.

Key Concept: Risk Assessment

b) External sources

[Solution Description] External sources often involve borrowing loans, issuing debentures, etc., which come with interest obligations. This makes them riskier compared to internal sources like ploughing back profits, which do not have such obligations.

Key Concept: Borrowed Funds

c) Public deposits

[Solution Description] Borrowed funds refer to sources of finance where the company borrows money and thus has an obligation to pay back with interest. Common sources include loans from banks, debentures, and trade credit.

Key Concept: Flexibility Analysis

d) Retained earnings

[Solution Description] Retained earnings provide the greatest flexibility since there are no external obligations or restrictions on how the funds can be used by the company.

Key Concept: Operational Freedom

d) They are generated internally

[Solution Description] Retained earnings are funds generated internally within the firm, which means they do not come with the constraints and obligations associated with external borrowings or issuing new equity. This allows companies to utilize these funds flexibly without having to adhere to the terms set by external financiers.

Key Concept: Long-term Planning, Complex Source Analysis

b) Equity shares and Commercial papers

[Solution Description] For extensive, multi-year retail expansion requiring large capital, an optimal mix of long-term sources like equity shares ensures no repayment pressure, coupled with commercial papers for short-term cash flow adjustments, aligning with sustainable growth strategy while managing liquidity.

Key Concept: Comparative Analysis

c) They are established by central and state governments to promote industrial development

[Solution Description] Financial institutions provide comprehensive support including financial, managerial, and technical advice. This differs from traditional banks or other lenders that mainly focus on providing loan capital.

Key Concept: Impact of Financing Periods, Long-term vs Short-term Decision Making

c) Primarily utilize long-term equity or debenture issuance

[Solution Description]

To finance this long-term project effectively, the company would need to cover both initial high R\&D costs as well as ongoing operating expenses. Since the revenue generation period extends beyond 5 years, primarily long-term sources such as shares or debentures are appropriate for ensuring financial stability and reducing refinancing risks. Short-term sources might not provide the necessary coverage due to their short span and higher interest rate fluctuations.

Key Concept: Merits Identification

b) They provide a fixed rate of return.

[Solution Description]

One of the merits of preference shares is that they provide a steady income with low risk, as they offer a fixed dividend rate, giving investors predictable returns.

Key Concept: Agency Role

b) International Finance Corporation

[Solution Description] International agencies and development banks play a crucial role in supporting economic growth by providing financial aid and loans with longer terms to projects aimed at development.

Key Concept: Limitations of Debentures

b) Fixed charges on earnings must be paid even if not profitable

[Solution Description] One limitation of debentures is that they impose fixed charges on earnings, which are mandatory regardless of the company’s profitability, leading to a permanent burden on earnings.

Key Concept: Scenario-Based

d) Debentures

[Solution Description]

The company should opt for a finance source that allows interest payments to be deducted from taxable income, which provides a direct tax benefit by reducing the amount of taxable income.

Debentures allow such deductions as their interest expenses are tax-deductible. Preference shares and equity shares do not provide this benefit since dividends paid on them are not tax-deductible. Therefore, issuing debentures will provide the desired tax savings.

Key Concept: Source Advantages

a) No interest costs involved

[Solution Description] Retained earnings are profits that have been reinvested into the company instead of being distributed as dividends. The main advantage is that they do not require repayment and incur no interest cost, unlike loans or debentures.

Key Concept: Creditworthiness Factors

b) The firm’s creditworthiness and goodwill

[Solution Description] The eligibility for trade credit largely relies on a firm’s creditworthiness and goodwill. Creditworthiness is evaluated based on financial stability, past payment records, and reputation.

Key Concept: Asset Charge

c) Assets can be freely used as security for other loans.

[Solution Description] Raising funds through equity shares does not create a charge or lien on the company’s assets. This means that the company’s assets can be freely used or mortgaged without any restriction from equity share capital, providing financial flexibility to the company.

Key Concept: Critical Analysis, Non-Straightforward Path

b) Improve inventory turnover

[Solution Description]

The firm could improve liquidity by improving inventory turnover, which reduces carrying costs and frees up cash tied in unsold goods. By aligning inventory purchase closer to demand, particularly just before peak seasons, the firm can maintain lower inventory levels during off-peak times, enhancing liquidity.

Key Concept: Basic Definition

c) To establish and run business operations

[Solution Description] Business finance focuses on providing funds necessary for establishing and running business operations efficiently.

Key Concept: Basic Definition

b) To enable foreign companies to raise capital in India

[Solution Description] The main purpose of IDRs is to enable foreign companies to raise capital in India without having to list directly on Indian stock exchanges. They represent the shares of a foreign company and allow Indian investors to invest in these shares in Indian Rupees.