What is the primary difference between debt and equity regarding tax treatment?

Interest payments on debt are tax-deductible expenses, which reduces the effective cost of borrowing. In contrast, dividends paid to equity holders are distributed from after-tax profits and provide no tax shield to the company.

When should a business choose a bank overdraft over a long-term loan?

An overdraft is appropriate for short-term timing differences in cash flow, such as covering a temporary deficit before a large receivable is collected. It should not be used for permanent asset acquisition because it is expensive and can be withdrawn by the bank on demand.

How does the 'Matching Principle' guide the selection of finance?

It suggests that the maturity of the funding source should align with the life of the asset. Long-term assets should be funded by long-term sources (equity/loans) to ensure the asset generates enough cash over its life to repay the capital, while short-term assets use short-term credit.

What is a common error when evaluating the cost of retained earnings?

The most common error is assuming retained earnings are free of cost. In reality, they have an opportunity cost equal to the required rate of return of the shareholders, as the money could have been paid out as dividends for them to invest elsewhere.

Why might a highly geared company struggle to raise further debt?

Lenders perceive high gearing as high financial risk because a large portion of operating profit is already committed to interest payments. This reduces the 'interest cover' and increases the likelihood that the firm will default on new obligations.

What is the risk of using short-term finance for long-term investments?

This creates refinancing risk and liquidity pressure. The business may be forced to repay or renegotiate the finance before the long-term asset has generated sufficient cash flow, potentially leading to a cash crisis if credit markets tighten.

Define 'Restrictive Covenants' in the context of debt finance.

These are conditions imposed by lenders in a loan agreement that limit the borrower's actions, such as restricting further borrowing or dividend payments. They are designed to protect the lender's interests by ensuring the company maintains a certain level of financial health.

What is 'Rights Issue'?

A rights issue is an offer to existing shareholders to purchase additional new shares in proportion to their existing holdings, usually at a discount to the market price. It allows a company to raise equity capital without necessarily diluting the control of current owners.

What does the Interest Cover ratio measure?

It measures the number of times a company can pay its current interest expenses out of its operating profit ($EBIT$). A higher ratio indicates a greater safety margin and lower risk for lenders.

Why is equity generally considered more expensive than debt for a company?

Equity is riskier for the investor because shareholders are the last to be paid in the event of liquidation and dividends are not guaranteed. Therefore, investors demand a higher risk premium (return) compared to lenders who have a prior claim on assets.

Selecting Sources of Finance | Cambridge International Examinations AS-Level Business

1. Core Determinants of Financial Choice

Cost of Capital: This represents the return required by providers of finance. Debt is generally cheaper than equity because interest is tax-deductible and lenders face lower risk than shareholders.
Financial Risk and Gearing: Gearing (or leverage) measures the proportion of debt in a firm's capital structure. High gearing increases the risk of insolvency if the business cannot meet fixed interest obligations during a downturn.
Control and Ownership: Issuing new equity can dilute the voting power of existing shareholders. Debt holders do not usually have voting rights but may impose restrictive covenants on how the business is managed.

A matrix showing the categorization of financial sources into Internal vs External and Short-term vs Long-term.

2. The Matching Principle

Concept of Maturity Matching: The duration of the finance should ideally match the expected life of the asset. For example, long-term assets like machinery or buildings should be funded by long-term sources like mortgages or equity.
Short-term Needs: Current assets (inventory, receivables) should be funded by short-term liabilities like trade credit or bank overdrafts to avoid paying interest on idle funds.
Risk of Mismatching: Using short-term finance for long-term assets creates refinancing risk, where the business may be unable to renew the loan when it expires, leading to a liquidity crisis.

3. Methods of Evaluation

Interest Cover Ratio: Calculated as $\frac{\text{Operating Profit}}{\text{Interest Expense}}$ . This determines if the business generates enough profit to service its debt; a low ratio suggests high financial risk.
Gearing Ratio: Calculated as $\frac{\text{Long-term Debt}}{\text{Equity + Long-term Debt}}$ . This indicates the financial leverage of the firm and its sensitivity to interest rate changes.
Weighted Average Cost of Capital (WACC): Businesses aim to select a mix of finance that minimizes the WACC, which is the average rate a company pays to finance its assets, weighted by the proportion of each source.

4. Key Distinctions: Debt vs. Equity

Feature	Debt Finance	Equity Finance
Obligation	Fixed interest payments required	Dividends are discretionary
Taxation	Interest is tax-deductible	Dividends are paid from after-tax profit
Risk	High risk of bankruptcy if unpaid	Low risk (no repayment obligation)
Control	No voting rights; restrictive covenants	Voting rights; potential dilution
Cost	Generally lower ( $K_d < K_e$ )	Generally higher due to risk premium

5. Exam Strategy & Tips

Analyze the Business Stage: Start-ups often lack the collateral for debt and the track record for public equity, making venture capital or personal savings more appropriate.
Check the Purpose: Always link the source to the specific use of funds. If the scenario describes a 10-year expansion project, immediately rule out overdrafts as a primary source.
Evaluate Existing Gearing: If a company already has high debt levels, look for equity-based solutions to avoid breaching bank covenants or risking insolvency.
Consider External Environment: In a high-interest-rate environment, debt becomes more expensive and riskier; equity or internal funds may be preferred despite higher nominal costs.

6. Common Pitfalls & Misconceptions

The 'Free' Finance Myth: Retained earnings are often viewed as free, but they carry an opportunity cost equal to the return shareholders could have earned elsewhere.
Over-reliance on Overdrafts: Students often suggest overdrafts for long-term projects because they are easy to access, ignoring that they are 'payable on demand' and can be withdrawn by the bank at any time.
Ignoring Tax Shields: Failing to account for the tax-deductibility of interest leads to an overestimation of the true cost of debt compared to equity.

Selecting Sources of Finance

Summary

1. Core Determinants of Financial Choice

2. The Matching Principle

3. Methods of Evaluation

4. Key Distinctions: Debt vs. Equity

5. Exam Strategy & Tips

6. Common Pitfalls & Misconceptions

Selecting Sources of Finance

Summary

1. Core Determinants of Financial Choice

2. The Matching Principle

3. Methods of Evaluation

4. Key Distinctions: Debt vs. Equity

5. Exam Strategy & Tips

6. Common Pitfalls & Misconceptions