9609 · 5.2.4
Selecting the source of finance flashcards
Revision flashcards for Cambridge 9609 Selecting the source of finance (syllabus 5.2.4). Flip, recall, then mark a real past-paper question.
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Recommend answer structure?
Options → pros/cons each → recommendation → justification from case.
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When prefer retained profit?
Profitable firm, sufficient reserves, owners want no debt or dilution.
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When prefer debt?
Owners keep control; tax relief on interest; predictable asset purchase.
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When prefer equity?
High risk, weak collateral, large sum, start-up, or already highly geared.
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Cash flow test for debt?
Forecast must show ability to pay interest and principal — use 5.3.1 cash flow.
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Combining sources?
Often optimal — e.g. retained profit + bank loan reduces interest and dilution.
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Evaluate not just recommend?
Show why rejected options are weaker, not only why chosen option is good.
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Link to 10.3 investment?
Large projects appraised with NPV then financed via selected source.
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What is 'gearing'?
A financial ratio that compares a company's debt capital to its equity capital. A high gearing ratio indicates a high level of debt and therefore higher financial risk.
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What is 'dilution of control'?
The reduction in the ownership percentage of existing shareholders caused by the issuing of new shares. Each shareholder owns a smaller piece of the company.
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What is the 'opportunity cost' of using retained profit?
The dividend income that shareholders have to forgo. Using retained profit for reinvestment means it cannot be distributed to owners, which may cause shareholder dissatisfaction.
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What is 'collateral'?
An asset that a borrower offers to a lender to secure a loan. If the borrower defaults on the loan, the lender has the right to seize the collateral to recoup its losses.
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What is the key difference between a share issue and a debenture issue?
A share issue is equity finance, selling ownership in the company. A debenture issue is long-term debt finance, essentially a loan from investors with a fixed interest rate and repayment date.