Question

Explain four major sources of finance for projects giving the advantages and disadvantages for each.

Answer 1

The major sources of financing any project are as under :

1) Issue of Share Capital -

Issue of share capital to general public is major source of finance used by public companies. Stocks ar offered to investors who pay cash for their shares and take an ownership stake in the company. The company can either issue Equity share capital or preference share capital for raising funds to finance the project.

The advantages of issuing share capital are as follows:

• It helps the firm in raising long term capital.
• There is no need to repay the shareholders. If the shareholder's are in need of funds they can sell their shareholding in the secondary markets.
• There is no obligation to pay dividends to equity shareholders in case the firm incurs loss.

The disadvantages of issuing share capital are as follows:

• If the company issues large amount of share capital, it will lead to dilution of ownership right of other shareholders.
• The firm will be responsible and accountable for conducting business.

2) Issue of debt -

Issue of debt is also the major source of financing for firms. The firm can issue debentures, bonds to public for raising funds. The debentureholders become the creditors of the company. Issue of debt provides tax benefit to the firm as the interest paid to debentureholders is tax deductable.

The advantages of issuing debt are as follows:

• Provides tax benefits.
• They don't have voting rights, hence don't dilute the ownership.

The disadvantages of issuing debt are as follows:

• The interest paid is charge against profit, has to be aid irrespective of profit or loss.
• Issue of more and more debt increase financial distress and chances of bankruptcy for the firm.

3) Retained Earnings-

Retained earnings are the part of profit which is kept aside after paying dividend. It is retained in the firm and can be used in case of emergency or financing the new projects.

The advantages of using retained earnings are as follows:

• It is the cheapest source of finance for a finance as no dividend or interest has to be paid on this.
• There is no dependence on anyone.
• There will be no floatation cost or issuing cost for the firm.

The disadvantages of using retained earnings are as follows:

• If the firms retains profits instead of paying dividends can be the major consideration for shareholders while investing in the firm.
• Retained profits can be misused by the management of the firm.

4) Venture Capital -

Venture capital firms are another source of financing for starting up a business or expanding a firm. It is a form of private equity that investors provide to start companies that are believed to have long term growth potential.

The advantages of using venture capital are as follows:

• Venture Capital provides the company with an opportunity to expand. They takes the risk and believes in company's long term growth.
• Venture capitalists provides valuable guidance.
• There is no obligation for repaying the venture capitals if the start up fails.

The disadvantages of using venture capital are as follows:

• It is a very long and complicated process to convince the venture capitalist to invest in the business.
• Because venture funding involves a huge amount of capital, the VC may not release all the funds at the same time.

Hope it helps!