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9609 · 5.2.3

Factors affecting the sources of finance — practice questions

Practice and worked examples for 9609 Factors affecting the sources of finance. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

A family-owned Ltd needs $2 m for a new factory. Owners refuse to lose control. Interest rates are high. Discuss two relevant factors.

Show solution outline

Control: Owners reject share issue to outsiders — prefer debt (bank loan, debentures) to keep 100% ownership, accepting higher gearing and interest cost.

Cost of finance: High interest rates make debt expensive — may delay project, seek government grant, or use retained profit partially to reduce borrowing.

Also consider duration — 15-year factory matched to long-term loan, not overdraft.

Worked example 2

Innovate Ltd needs to raise $500,000 for new product development. The project is expected to generate profits after two years. The company's current profit before interest and tax is $200,000. The company is considering two options:

  1. A 5-year bank loan at a fixed interest rate of 8% per annum.
  2. Issuing 100,000 new shares at $5 per share. The company expects to pay an annual dividend of $0.30 per share on all shares. The company currently has 400,000 shares in issue. Calculate the annual cost of each option and recommend a source of finance, justifying your answer.
Show solution outline

Step 1: Calculate the annual cost of the bank loan (Debt Finance)

  • Loan amount = 500,000500,000
  • Interest rate = 8% per annum
  • Annual Interest Cost = Loan Amount × Interest Rate
  • Calculation: 500,000×0.08=∗∗500,000 \times 0.08 = **40,000** The annual cost of the bank loan is $40,000. This is a fixed, legally required payment.

Step 2: Calculate the annual cost of issuing shares (Equity Finance)

  • Number of new shares = 100,000
  • Expected dividend per share = 0.300.30
  • Annual Dividend Cost (on new shares) = Number of new shares × Dividend per share
  • Calculation: 100,000 × 0.30=∗∗0.30 = **30,000** The annual cost in terms of dividends for the new capital is $30,000. Note that dividends are paid out of after-tax profits and are not a legal obligation.

Step 3: Analysis and Recommendation

  • Cost: The immediate annual dividend cost ($30,000) is lower than the annual interest cost ($40,000). However, loan interest is tax-deductible, which reduces its effective cost, while dividends are not.
  • Control: The bank loan involves no loss of control. Issuing 100,000 new shares would increase total shares to 500,000 (400,000 existing + 100,000 new). The new shareholders would own 20% (100,000 / 500,000) of the company, diluting the control of existing owners.
  • Risk: The loan interest of $40,000 is a fixed cost that must be paid regardless of profitability, increasing financial risk (gearing). As the project will not generate profits for two years, this could strain cash flow. Dividend payments are flexible and can be cancelled if profits are low.
  • Recommendation: Given the two-year delay before the project generates profit, the flexibility of equity finance is a significant advantage. The risk of being burdened with mandatory interest payments when cash flow is tight is high. Therefore, issuing shares is likely the more prudent option, despite the dilution of ownership.
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