Chapter 8 Sources of Business Finance NCERT SOLUTION CLASS 11TH Business studies | EDUGROWN NOTES

Short Answer Type Question:

Q.1  What is business finance? Why do businesses need funds? Explain

ANSWER: Finance is the life blood of a business and the money required to run the business is known as business finance.

Business needs finance for three reasons mainly:

• To purchase plant and machinery, land, buildings and other fixed assets (Fixed capital requirements).
• Smooth functioning of day to day operations of the business (Working capital requirements)
• Expansion, growth and diversification.
  

Q.2 List sources of raising long-term and short-term finance. 

ANSWER:  Long-term financial resources are:

• Equity Shares
• Retained earnings
• Preference shares
• Debentures
• Loans from financial institutions
• Loans from Banks

Short-term financing sources are:

• Trade credit
• Factoring
• Banks
• Commercial papers
  

Q.3 What is the difference between internal and external sources of raising funds? Explain.

ANSWER: The difference between internal and external sources of raising funds are as follows:

S.No.	Basis of Comparison	Internal Source	External Source
1	Meaning	Funds generated from within the organization are known as internal sources.	Funds generated from sources outside the organisation are called external sources
2	Needs	Only short term or limited needs could be fulfilled by this source.	Large amounts of money requirements are fulfilled through external sources.
3	Security	No security required	Security required by way of collateral assets
4.	Cost	Less expensive	These are more expensive sources than internal sources of financing.
5.	Examples	Ploughing back of profit,  Disposing surplus inventory, etc.	Borrowings from commercial banks, Acceptance of Public deposits, Raising debentures etc.

Q.4 What preferential rights are enjoyed by preference shareholders. Explain.

ANSWER: Preference shareholders have the following preferred rights:  

• Preference in Dividend: They receive dividends at a fixed rate, and dividends on these shares are paid before dividends on equity shares.
• Preference in Repayment: When a corporation closes, preference shares are paid out first, followed by equity shares.
• Excess Profits: Preference shares have the right to partake in any excess profits that remain after equity shares have been paid.
• Preference in case of dissolution: They have the preference over equity shareholders in the share capital refund in the event of company dissolution.
  

Q.5 Name any three special financial institutions and state their objectives.

ANSWER: The three institutions are:

• Unit Trust of India or UTI: It was established under Unit Trust of India Act, 1963 in 1964. The purpose of the establishment of the UTI was supposed to combine savings and monetization of investment in profitable businesses.
• The Industrial Finance Corporation of India or IFCI: It was established in 1948, under Industrial Finance Corporation Act, 1948. Its purpose was to assist in balanced regional development, encouraging entrepreneurs to enter emerging sectors, and to contribute to management education development.
• State Financial Corporation (SFC): SFC’s fulfils the long term, and medium term finance needs of industries which are beyond the scope of IFCI. It covers public limited, private limited, partnership firms as well, thus its scope is broader than IFCI.
  

Q.6 What is the difference between GDR and ADR? Explain.

ANSWER: the difference between GDR and ADR is:

Basis	GDR	ADR
Meaning	A GDR is a negotiable instrument or an instrument that can be traded freely in various foreign capital markets.	This instrument is like a regular stock which is purchased and sold in American markets.
Stands for	Global Depository Receipt	American Depository Receipt
Issued by	These are issued by Indian enterprises in order to raise capital from foreign investors.	It is issued by American businesses and can be traded on American stock exchanges. Only American citizens are eligible to receive it.
Traded on	It is traded on foreign stock exchanges.	Only be traded in US stock exchanges.

Q.7 Explain trade credit and bank credit as sources of short-term finance for business enterprises.

ANSWER: Trade Credit

It refers to the extension and provision of credit by one one trader to another for the purchase of goods and services, or other supplies without on the spot payment.. 

This is generally used by organizations as short term financing. The terms of trade credit may vary from person to person based on past records and from industry to industry based on industry norms.

Merits

• A continuous and a convenient source of funds.
• It is readily available if credit worthiness is known to the seller.
• It helps in increasing the inventory levels in case of increase in sales volume.
• While providing funds, It does not create a charge on assets of the firm .

Limitations

• There can be chances of over-trading.
• Fulfils only limited financial needs.
• Costly in comparison to few other sources.

Bank Credit

A loan provided by a bank to a business firm is known as bank credit. The bank’s interest rate on the loan is usually determined by the current interest rate in the economy. To secure the loan, the borrower must mortgage assets with the bank.

Advantages 

• Secrecy of business is maintained.
• An easier source of finance as formalities of issuing of prospectus and underwriting is not required.
• Bank credit gives the borrower flexibility because the amount of the loan can be increased or decreased depending on the borrower’s business demands.

Disadvantages

• Generally, the funds are available for a short period of time and renewal becomes a difficult process and is uncertain.
• The company may have to keep assets as security as the banks ask for security assets before issuing such loans.
• Sometimes, the terms and conditions imposed by the banks are quite difficult.
• Banks’ terms are frequently highly restrictive; for example, a bank that has provided a loan may limit the borrower’s ability to sell commodities mortgaged to it.
  

Q.8 Discuss the sources from which a large industrial enterprise can raise capital for financing modernization and expansion.

ANSWER: The following are some long-term funding options:

• Equity shares: These shares represent a company’s ownership capital. These shareholders are known as equity shareholders, and they have a say in the management and benefit from higher returns when profits are higher. They are also known as the company’s owners, or residual owners because payments to them are provided only after external debts or claims have been paid.
• Retained earnings: Before paying out dividends to shareholders, companies often keep a portion of their income. These undistributed profits are referred to as retained earnings since the money is kept for future use.
• Preference shares: As the name suggests, these shareholders are the ones who hold a preferential position in respect to getting a fixed rate of dividend before any dividend for the equity shareholders, and receiving the capital at the time of liquidation just after the payment to the creditors of the company.
• Debentures: Debentures are long-term debt capital raising financial instruments employed by companies. They signify that a corporation has borrowed a particular amount of money, which it will eventually repay to the holders of debentures. They have a predetermined rate of return and a stipulated time for debt payback. Debenture holders are called the creditors of the company. 
• Bank and other financial institution loans: Businesses can borrow funds from banks and financial institutions for a certain period of time in exchange for a defined periodic payment known as interest. The repayment period for such a loan is predetermined and announced at the time of loan approval.
  

Long Answer Type Question:

Q.1 Explain trade credit and bank credit as sources of short-term finance for business enterprises.

ANSWER: Trade credit is the credit extended by one trader to another for the purchase of goods and services. Trade credit facilitates the purchase of supplies without immediate payment. Trade credit is commonly  used  by  business organisations as a source of short-term financing. It is granted to those customers who have reasonable amount of financial standing and goodwill.

• Merits of trade credit as a source of short-term finance:
→ Trade credit helps a company to finance the accumulation of inventories for meeting future increase in sales.
→ As the trade creditors do not have any rights over the assets of the company, it can mortgage its assets to raise money from other sources.

• Demerits of bank credit as a source of short-term finance:https://704a05148f9ca4a81fff005e88b98af1.safeframe.googlesyndication.com/safeframe/1-0-38/html/container.html→ It is difficult to increase the loan.
→ The terms imposed by banks are often very restrictive as example, the bank that has granted a loan may restrict the sale of goods mortgaged to it by the borrower.

Q.2 Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion.

ANSWER: Industrial Finance Corporation of India (IFCI): It was established in July 1948 as a statutory corporation under the Industrial Finance Corporation Act, 1948. Its objectives include assistance towards balanced regional development and encouraging new entrepreneurs to enter into the priority sectors of the economy. IFCI has also contributed to the development of management education in the country.

→ Industrial Credit and Investment Corporation of India (ICICI): This was established in 1955 as a public limited company under the Companies Act. ICICI assists the creation, expansion and modernisation of industrial enterprises exclusively in the private sector. The corporation has also encouraged the participation of foreign capital in the country.

→ Industrial Development Bank of India (IDBI): It was established in 1964 under the Industrial Development Bank of India Act, 1964 with an objective to coordinate the activities of other financial institutions including commercial banks. The bank performs three types of functions, namely, assistance to other financial institutions, direct assistance to industrial concerns, and promotion and coordination of financial-technical services.

→ Unit Trust of India (UTI): It was established by the Government of India in 1964 under the Unit Trust of India Act, 1963. The basic objective of UTI is to mobilise the community’s savings and channelise them into productive ventures. For this purpose, it sanctions direct assistance to industrial concerns, invests in their shares and debentures, and participates with other financial institutions.

→ Industrial Investment Bank of India Ltd.: It was initially set up as a primary agency for rehabilitation of sick units and was known as Industrial Reconstruction Corporation of India. It was reconstituted and renamed as the Industrial Reconstruction Bank of India in 1985 and again in 1997 its name was changed to Industrial Investment Bank of India. The Bank assists sick units in the reorganisation of their share capital, improvement in management system, and provision of finance at liberal terms.

→ Life Insurance Corporation of India (LIC): LIC was set up in 1956 under the LIC Act, 1956 after nationalising 245 existing insurance companies. It mobilises the community’s savings in the form of insurance premia and makes it available to industrial concerns, both public as well as private, in the form of direct loans and underwriting of and subscription to shares and debentures.

Q.3 What advantages does issue of debentures provide over the issue of equity shares?

ANSWER: Debentures are long term debts by which a company can raise funds which bear a fixed rate of interest. The debenture issued by a company is an acknowledgment that the company has borrowed a certain amount of money, which it promises to repay at a future date.

The advantage of issue of debentures over the issue of equity shares are:

→ The issue of equity shares means dilution of ownership of a firm while debentures holders do not have any rights in the company. They do not enjoy voting rights or any kind of ownership in the firm. They are only entitled to a fixed amount as payment.

→ For issuing shares a company has to incur huge costs. Also, it has to pay dividends to its shareholders, which are not tax deductible while a company receives tax deductions on the interest paid to its debenture holders. Therefore, issuing debentures is advantageous for a firm in terms of low costs.

→ Debentures carry a fixed rate of return which means that irrespective of the profit earned, the company has to pay only a fixed interest to its debenture holders while a company that issues shares has to pay dividends to the shareholders, which varies with the profit i.e., the higher the profit, the higher will be the dividends.

Q.4 State the merits and demerits of public deposits and retained earnings as methods of business finance.

ANSWER: Public Deposits
The deposits that are raised by organisations directly from the public are known as public deposits. Rates of interest offered on public deposits are usually higher than that offered on bank deposits. Any person who is interested in depositing money in an organisation can do so by filling up a prescribed form. The organisation in return issues a deposit receipt as acknowledgment of the debt.

• Merits of Public deposits are:

→ The procedure of obtaining deposits is simple and does not contain restrictive conditions as are
generally there in a loan agreement
→ Cost of public deposits is generally lower than the cost of borrowings from banks and financial
institutions
→ Public deposits do not usually create any charge on the assets of the company. The assets can be used as security for raising loans from other sources
→ As the depositors do not have voting rights, the control of the company is not diluted.

• Demerits of Public deposits are:
→ New companies generally find it difficult to raise funds through public deposits
→ It is an unreliable source of finance as the public may not respond when the company needs money
→ Collection of public deposits may prove difficult, particularly when the size of deposits required is large.

Retained earnings
Business enterprise keep a portion of the net earnings may be retained in the business for use in the future. This is known as retained earnings. It is a source of internal financing or self- financing or ‘ploughing back of profits’.

• Merits of Retained earnings are:
→ Retained earnings is a permanent source of funds available to an organisation
→ It does not involve any explicit cost in the form of interest, dividend or floatation cost
→ As the funds are generated internally, there is a greater degree of operational freedom and flexibility
→ It enhances the capacity of thebusiness to absorb unexpected losses;
→ It may lead to increase in the market price of the equity shares of a company.

• Demerits of Retained earnings are:
→ Excessive ploughing back may cause dissatisfaction amongst the shareholders as they would get lower dividends;
→ It is an uncertain source of funds as the profits of business are fluctuating;
→ The opportunity cost associated with these funds is not recognised by many firms. This may lead to sub-optimal use of the funds.

Q.5 Discuss the financial instruments used in international financing.

ANSWER: The financial instruments used in international financing are:
→ Global Depository Receipts (GDRs): These are receipts issued by depository banks against the shares of a company. Such depository receipts denominated in US dollars are known as Global Depository Receipts (GDR). GDR is a negotiable instrument and can be traded freely like any other security. In the Indian context, a GDR is an instrument issued abroad by an Indian company to raise funds in some foreign currency and is listed and traded on a foreign stock exchange.

→ American Depository Receipts (ADR’s): The depository receipts issued by a company in the USA are known as American Depository Receipts. ADRs are bought and sold in American markets like regular stocks. It is similar to a GDR except that it can be issued only to American citizens and can be listed and traded on a stock exchange of USA.

→ Foreign Currency Convertible Bonds (FCCBs): These bonds are debt securities that are convertible into equity shares or depository receipts after a specific period of time. The terms and prices of such conversions are generally specified in advance. The return on such securities is pre-fixed and lower than the return on non-convertible securities.

Q.6 What is a commercial paper? What are its advantages and limitations.

ANSWER: Commercial paper is an unsecured promissory note issued by a firm to raise funds for a short period, varying from 90 days to 364 days. It is issued by one firm to other business firms, insurance companies, pension funds and banks. The amount raised by CP is generally very large. As the debt is totally unsecured, the firms having good credit rating can issue the CP. Its regulation comes under the purview of the Reserve Bank of India.

• Advantages of Commercial paper are:
→ A commercial paper is sold on an unsecured basis and does not contain any restrictive conditions;
→ As it is a freely transferable instrument, it has high liquidity;
→ It provides more funds compared to other sources. Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans;
→ A commercial paper provides a continuous source of funds. This is because their maturity can be tailored to suit the requirements of the issuing firm. Further, maturing commercial paper can be repaid by selling new commercial paper;
→ Companies can park their excess funds in commercial paper thereby earning some good return on the same.

• Limitations of Commercial paper are:
→  Only financially sound and highly rated firms can raise money through commercial papers. New and moderately rated firms are not in a position to raise funds by this method.
→ The size of money that can be raised through commercial paper is limited to the excess liquidity available with the suppliers of funds at a particular time;
→ Commercial paper is an impersonal method of financing. As such if a firm is not in a position to redeem its paper due to financial difficulties, extending the maturity of a CP is not possible.