Question

Question A. What factors should management consider in choosing among the various sources of external capital?

Question B. What is the ICGR, and why is it important to the management of a financial firm?

Answer 1

A)

Choosing an appropriate source of business finance can be a difficult and time-consuming task. This is due to the sheer amount of funding options available. Financing can come in the form of debt or investment, and finance terms can vary significantly.The criteria and implications of each source require critical analysis before proceeding, and it is essential to weight the cost versus benefits of each source before making a decision.

Below are some of the factors that we should consider before deciding on a source that most suits our business needs.

1) Risk

Risk is an important element to consider. We must consider what will happen if we are unable to meet the financial commitments relating to that particular source of finance. If we borrow from friends and family, for example, we will need to take into account what would happen to our relationship with them should the business fail and we are unable to repay them.

What will happen if we are unable to meet the financial commitments of a bank loan if our business succumbs to financial difficulty? When it comes to choosing suitable funding, we must strive to minimise the overall risk.

2) Cost

The cost of finance and its effect on income will play a fundamental role in our financing decision. Our overall aim is to minimise the cost of finance and maximise owners wealth. Therefore, it is essential to consider the implications of choosing one source of funding over another.

If they consider that the additional borrowing increases the risk of bankruptcy then they may require an additional return as compensation for this risk. Therefore, this compensation will represent an increase in the cost of equity. We also need to consider the other costs of borrowing which include interest rates, origination fees, and brokers’ fees.Financing through issuing new shares can lead to a change in management and a shifting in strategic focus. In addition, the costs associated with issuing new shares can be substantial and there is also uncertainty with regards to the success of the issue.

3) Control

Control is another factor that plays an important role when choosing a source of finance. Issuing additional shares (equity) will result in a dilution of control among existing shareholders/owners. You are effectively giving each investor a piece of ownership in your business and thereby are accountable to those shareholders.

Investors will require input into the operations such as sitting on the board of directors and receiving performance and operation reports. You will have to provide them with information that you may have wished to keep hidden from your competition, as well as detailed explanations for your business decisions.

4) Long term versus short term borrowing

When sourcing finance, we also need to consider whether we should obtain long term or short term funding. In many cases, it may be appropriate to match the type of funding to the nature of the asset.

If we are obtaining a noncurrent asset, for example, a piece of machinery that will form a permanent part of our operating base, then we would consider using a long term source of finance to fund this asset.Long term finance will be repaid over a longer period and include bank loans, hire purchase, debentures and retained profits for example.

On the other hand, if we were obtaining an asset that was more flexible in nature and could be paid at short notice, such as an asset obtained to meet seasonal demand or money to cover the day-to-day operations of our business, then we would finance this using a short term source of finance.

Finally, interest rates will play a fundamental role when we are deciding our financing options. Due to the increased risks associated with long-term borrowing, lenders will require extra as compensation for this increased risk as their funds are tied up longer. This will be reflected in higher interest rates.

Lenders often require additional security to safeguard against you defaulting on a loan. For example, if you obtain a mortgage you are using your house as security so if you don’t repay the loan amount, your property may be repossessed by the lender and sold to recoup the money owed.While this may make short-term funding more desirable, it is critical to consider the other costs as short-term financing will need to be reviewed more regularly thereby increasing costs.

B) Internal capital generation rate (ICGR)

The internal capital generation rate (ICGR) is a quantifiable mathematical rate that portrays how quickly a bank is able to generate. The internal capital generation rate is calculated by dividing the bank's retained earnings by the average balance of the combined equity of all stockholders for a given accounting period. The bank's retained earnings are found by subtracting dividends paid from net income using the income statement, while the value of owners' equity can be found on the balance sheet.

CGR stands for Internal Capital Generation Rate. It is the capital retained by the financial firm after paying the dividend amount. It is very important to a financial firm as ICGR directly indicates the growth of new avenues for return on investment that will be received on retained capital after investment. As it is the ratio of retained capital over average equity carried by the firm, it also directly impacts the stock price of the financial firm.