Question

Scenario

The board of Penco approved your recommendations and decided to purchase stock in the two organisations you recommended. In fact, based on your recommendations, they decided to invest more than anticipated. The previous budget was £2,000,000 but the board wants to invest £1,000,000 in each of the two organisations you recommended which means that an extra £1,000,000 is required. Instructions:

Write a short report containing:

▪ An introduction discussing the need for short term working capital and long-term funds

▪ A main body comparing the sources of funding, including their pros and cons

▪ A justified recommendation of your choices of funding for the £1,000,000 using a range of criteria related to cost and risk.

Please 1500 words

Answer 1

Working capital is very essential to maintain smooth running of a business. No business can however run successfully without an adequate amount of working capital which could be further categorized to short term and long term working capital.

Short term working capital is defined as current assets/current liabilities of a company. Generally, when a small business is looking for a working capital loan, they’re looking to add financing that allows them to bridge these differences. Short term working capital is essential for a company to meet up unexpected financial emergencies and to take advantage of immediate opportunities. Short term working capital is needed to fund obligations to suppliers, employees and the government while waiting for payments from customers.

A long term working capital is a loan that has a tenor of more than 12 months.
The primary advantages of these loans include:
1. Has lower interest rates as compared to that on short-term loans.
2. Gives more repayment time, thus enabling a business to adjust its borrowings with its long-term plans.
3. Provides flexibility by making it easier for businesses to repay it.
Businesses can use a long term working capital to maintain a healthy working capital or to fund its long-term growth plans.

Short Term Working capital sources with its pros and cons:

Banks can be an invaluable source of short term working capital finance.

1. Overdraft Agreement:

By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to a certain limit without the need for further discussion. The bank might ask for security in the form of collateral and they might charge daily interest at a variable rate on the outstanding debt. However, if the business is confident of making the repayments quickly, then an overdraft agreement is a valuable source of financing, and one that many companies resort to. However, it runs a risk of a decrease in the limit or withdrawal of the limit. Reduction in the withdrawal of limit may happen usually when company financials may represent poor performance; hence, the facility may be withdrawn especially when the company may require it the most. The company also may run a risk of those assets being seized if it fails to meet payments.

2. Accounts Receivable Financing:

Many banks and non-banking financial institutions provide invoice discounting facilities. The company takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due date the bank collects the money from the customer. This is another popular method of financing especially among small traders. Businesses that offer large terms of credit can carry on their operations without having to wait for the customers to settle their bills. Various cons of such financing is as follows:   Higher Costs: While it is a quick way of accessing cash for your business, it may come at higher costs than the rates charged on other types of business loans. Remember that failure to pay back the amount within the predetermined period will only increase the total amount that you will be required to pay. Lengthy Contracts: Some agreements can be short and viable, but others can be long and winding than you would like. It is crucial, however, to negotiate the length of the contract that perfectly works for you and your business.

3. Customer Advances:

There are many companies that insist on the customer making an advance payment before selling them goods or providing a service. This is especially true while dealing with large orders that take a long time to fulfill. This method also ensures that the company has some funds to channelize into its operations for fulfilling those orders. Relying on Customer advances could be tricky as its dependability depends on the performance of the company and its fullfillment towards its customer demands as per agreement. Any breach from the agreement will lead to repayment of the advance back to the customer or cancellation of the order permanently.

Long Term Working capital sources with its pros and cons :

1. Shares:

Issue of shares is the most important source for raising the permanent or long-term capital. A company can issue various types of shares as equity shares, preference shares and deferred shares. According to the Companies Act, 1956, however, a public company cannot issue deferred shares.

Preference shares carry preferential rights in respect of dividend at a fixed rate and in regard to the repayment of capital at the time of winding up the company. Equity shares do not have any fixed commitment charge and the dividend on these shares is to be paid subject to the availability of sufficient profits. As far as possible, a company should raise the maximum amount of permanent capital by the issue of shares.

The dividend which a shareholder receives is neither fixed nor controllable by investor. The management of the company decides how much dividend should be given. If there is a loss, there is no question of dividend.

Equity share investment is a risky investment as compared to any other investment like debts etc. The money is invested based on the faith an investor has in the company. There is no collateral security attached with it.

2. Debentures:

A debenture is an instrument issued by the company acknowledging its debt to its holder. It is also an important method of raising long-term or permanent working capital. The debenture-holders are the creditors of the company. A fixed rate of interest is paid on debentures. The interest on debentures is a charge against profit and loss account.

The debentures are generally given floating charge on the assets of the company. When the debentures are secured they are paid on priority to other creditors. The debentures may be of various kinds such as simple, naked or unsecured debentures, secured or mortgaged debentures, redeemable debentures, irredeemable debentures, convertible debentures and non-convertible debentures.

The debentures as a source of finance have a number of advantages both to the investors and the company. Since interest on debentures have to be paid on certain predetermined intervals at a fixed rate and also debentures get priority on repayment at the time of liquidation, they are very well suited to cautious investors. The firm issuing debentures also enjoys a number of benefits such as trading on equity, retention of control, tax benefits, etc.

The major downsides to this option is restrictions imposed by securing the debenture with an asset or asset class, takes away the management’s freedom to control or use the assets at will. By holding a debenture, the lender loses their right to vote and take a share of company profits.

3. Public Deposits:

Public deposits are the fixed deposits accepted by a business enterprise directly from the public. This source of raising short term and medium-term finance was very popular in the absence of banking facilities. In the past, generally, public deposits were accepted by textile industries in Ahmedabad and Bombay for periods of 6 months to 1 year. But now-a-days even long-term deposits for 5 to 7 years are accepted by the business houses.

Public deposits as a source of finance have a large number of advantages such as very simple and convenient source of finance, taxation benefits, trading on equity, no need of securities and an inexpensive source of finance. But it is not free from certain dangers such as it is uncertain, unreliable, unsound and inelastic source of finance.

5. Loans from Financial Institutions:

Financial institutions such as Commercial Banks, Life Insurance Corporation, Industrial Finance Corporation long-term loans.This source of finance is more suitable to meet the long-term demands of working capital. Interest is charged on such loans at a fixed rate and the amount of the loan is to be repaid by way of installments in a number of years. Interest on debt is a permanent burden to the company. The company has to pay the interest to bondholders or creditors at fixed rate whether it earns a profit or not. It is legally liable to pay interest on the debt.

Ideal choices of funding for the £1,000,000

When recommending a financing method, consideration should be given to a number of factors like Cost and cash flows, Security and covenants, Risk, Availability and maturity, Costs and ease of issue and Control.

Given the recent performance and the good forecasts, the company is likely to have many finance sources available to it. Debt providers should be willing to lend and shareholders would be likely to support a rights issue.Equally, other investors may well wish to invest in the equity of the company.As the finance is required to finance a permanent expansion of the company, long-term finance should be raised.To the extent that the expansion requires investment inadditional working capital, some short-term finance could be raised.

Keeoing in view of the above factors, Penco should seek to finance the expansion by raising long-term debt secured on the existing non-current assets of the company and the new non-current assets acquired during the expansion.At the same time as raising the new debt, the refinancing of the existing debt should also be considered.If shareholders and other key stakeholders are concerned about the financial risk exceeding the industry average, then Penco could raise some short-term debt with the aim of repaying it as soon as more cash is earned. The impact on gearing could also be reduced by acquiring some assets on operating leases, or by the sale and lease back of some existing assets.The directors should take action to manage the interest rate risk that Penco will suffer.