9609 · 5.2.3
Factors affecting the sources of finance — FAQ
Frequently asked questions for 9609 Factors affecting the sources of finance. Direct answers first, then deeper explanation — then practise with marking.
Is debt finance always cheaper than equity finance?
Initially, debt can appear cheaper because interest rates are often lower than the expected returns (dividends and capital growth) for shareholders. However, high levels of debt increase financial risk (gearing). If interest rates rise or profits fall, a highly geared business can face insolvency. Furthermore, interest payments are a legal obligation, whereas dividend payments are not. So, while the 'headline' cost may be lower, the overall risk-adjusted cost can be higher.
If a business needs finance, can't it just choose the best option?
Not necessarily. The choice is heavily restricted by 'availability'. A small, new business has a very limited menu of options, often relying on owner's capital or small bank loans. A large, established Plc can access a much wider range, including the stock market. The economic climate, the business's credit history, and its current level of debt all act as constraints, meaning the 'best' theoretical option may not be an accessible one.
Does taking out a bank loan mean the bank can control my business?
No, not in the same way as a shareholder. A bank is a lender (a creditor), not an owner. They have no voting rights and cannot dictate business strategy. However, the loan agreement will contain 'covenants' – conditions the business must meet, such as maintaining certain financial ratios. If the business breaches these covenants or fails to make repayments, the bank can take legal action, which may include seizing assets pledged as security (collateral). This is a loss of assets, not a loss of ownership control.