Types of Financing: formula sheet

Key formulas

Classification by period

Short-term: up to 1 year | Medium-term: 1 to 5 years | Long-term: more than 5 years

These are the usual textbook limits. Say 'generally' in your answer. Split term loans by tenor: 1 to 5 years is medium-term, over 5 years is long-term.

Classification by ownership

Total funds = Owners' funds + Borrowed funds

Owners' funds: equity, reserves, retained earnings. Preference capital is a hybrid: part of share capital in the balance sheet, but treated like debt in cost-of-capital and financing-decision questions, so state which treatment you follow. Borrowed funds: debentures, loans, deposits, trade credit. They generally carry interest or a financing cost; trade credit has no explicit interest, only an implicit cost if a cash discount is forgone.

Matching principle

Long-term assets ← long-term funds; short-term needs ← short-term funds

Use this to justify the choice of source in case-based questions.

VC stage order

Seed → Start-up → Expansion (second) → Later stage → Exit (IPO / trade sale / buy-back)

Use this sequence to structure any stage-wise answer. Bridge finance sits just before the exit.

Funding cost vs. risk logic

Higher business risk → higher return demanded by investor → more equity-like instrument

Explains why early-stage money is equity or convertible, not plain debt.

VC vs. PE

VC = young, high-growth, smaller cheques, minority stake; PE = mature firms, larger cheques, often control or large stake

A usual tendency, not a legal rule. Say 'generally' in answers.

Investor return on exit

Gain = Exit proceeds − Investment; Multiple = Exit proceeds ÷ Investment

Handy for numerical questions on VC returns.

Present value of lease rentals

PV of rentals = Σ [Rental in year t ÷ (1 + k)^t]

k is normally the after-tax cost of borrowing when comparing lease with borrow-and-buy. Use after-tax rentals if rentals are tax deductible.

Annual lease rental (equated)

Rental = Cost of asset ÷ PV annuity factor (n years, rate r)

Used by the lessor to fix a rental that recovers cost and return. If there is a residual value, deduct its PV from cost first.

Net advantage of leasing (NAL)

NAL = PV of cost of buying − PV of cost of leasing

Positive NAL means lease. Negative NAL means buy. Be consistent with the cash outflows you treat as costs.

Tax shield on rentals

Tax saved = Rental × tax rate

After-tax rental = Rental × (1 − tax rate).

Tax shield on depreciation

Tax saved = Depreciation × tax rate

Relevant for the buy option. Depreciation is a non-cash item, so only the tax saving is a cash flow.

Effective annual cost of forgoing cash discount

Cost = [Discount % ÷ (100 − Discount %)] × [365 ÷ (Credit period − Discount period)]

Use days. This is the simple annualised form. Compounded form is (1 + d ÷ (100 − d))^(365 ÷ days) − 1. Use the form the question asks for.

Discount on bill or commercial paper

Discount = Face value × Discount rate × Days ÷ 365

Net proceeds = Face value − Discount. Check whether the question says 360 or 365 days.

Effective cost of discounting

Effective rate = (Discount ÷ Net proceeds) × (365 ÷ Days)

Divide by net amount received, not face value. Add any fees to the discount before dividing.

Cost of factoring

Cost = (Factoring commission + Interest on advance) ÷ Advance received, annualised

Deduct savings such as saved credit-administration cost and bad debts (non-recourse) before finding net cost.

Factor advance

Advance = (Receivables × Advance %) − Commission − Interest

Interest is on the advance for the collection period. Reserve is the balance held back.

Return on a zero coupon bond (approximate yield)

Issue price = Redemption value ÷ (1 + r)ⁿ

Solve for r to find the yield. Use this to price or compare a zero coupon or deep discount bond.

ADR vs GDR rule

ADR = US market, listed on US exchanges; GDR = other markets, or more than one market

State this contrast first in any difference question.

Securitization chain

Originator → sells asset pool → SPV → issues securities → investors; collections → investors

Write the flow in this order to earn process marks.

FCCB conversion value

Conversion value = Number of shares per bond × Market price per share

Compare with the bond's redemption value to judge whether conversion is worthwhile.

Quick revision

• Long-term sources fund fixed assets and growth, short-term sources fund working capital, and medium-term sources sit in between.
• Equity shares carry ownership and risk, with no fixed dividend and no fixed repayment.
• Preference shares get a preferential dividend and repayment, but usually no voting rights in ordinary matters.
• Debentures are debt with fixed interest, and the interest is tax-deductible for the company.
• Debt raises financial risk, while equity dilutes control.
• Venture capital funds early-stage, high-risk businesses in exchange for equity and often a say in management.
• Private equity usually invests in more established firms, often to support growth or restructuring.
• A finance lease transfers substantially all the risks and rewards of the asset to the lessee. A long lease term, often covering most of the asset's life, is one indicator, not a condition. In an operating lease, the lessor keeps them. Ind AS 116 removes the finance versus operating distinction for lessees, who recognise a right-of-use asset and a lease liability for most leases. Lessors still classify their leases as finance or operating.
• In hire purchase, the hirer becomes owner after paying the last instalment, while a lessee never gets ownership unless the lease says so.
• Trade credit is a common, convenient short-term source that looks free, but forgoing a cash discount makes its effective cost high. Compare that cost with bank finance.
• Commercial paper is a short-term unsecured money market instrument issued by strong, creditworthy companies.
• For lease versus buy, compare the present value of the after-tax cash outflows of each option, discounted at the post-tax cost of debt, and choose the lower.

Common mistakes

• Treating period limits as exact legal rules. Fix: Write 'generally' or 'usually'. Judge by how long the asset or need lasts.
• Mixing up classification by period with classification by ownership. Fix: Write the basis first, then place each source. A source such as a debenture is long-term and borrowed at the same time.
• Treating venture capital and private equity as identical. Fix: Remember VC targets young high-growth firms with smaller investments. PE targets mature firms with larger investments, often seeking control or restructuring.
• Listing VC stages out of order or mixing bridge finance with seed. Fix: Tie each stage to what the firm is doing: idea, launch, growth, maturity, pre-exit.
• Treating depreciation as a cash outflow in the buy option. Fix: Depreciation is non-cash. Include only the tax saving on it (Depreciation × tax rate).
• Discounting after-tax cash flows at the pre-tax rate of interest. Fix: Unless told otherwise, convert to after-tax: rate × (1 − tax rate), then discount after-tax cash flows.
• Dividing the discount by face value instead of net proceeds when finding effective cost. Fix: The company only receives the net amount, so divide by net proceeds.
• Treating trade credit as free. Fix: If a cash discount is offered, skipping it has a cost. Compute it before deciding.
• Saying a GDR can only be listed in London or that an ADR can be listed anywhere. Fix: Remember ADR is for the US market. GDR is for other or multiple markets. London is only an example.
• Writing that the issuer bears the currency risk on masala bonds. Fix: A masala bond is rupee-denominated, so the investor bears the exchange rate risk.

Exam tips

• Always state the basis of classification in your first line. It shows structure and earns marks.
• In 5 mark questions, give each source a feature, a merit and a limitation in short bullet lines.
• For MCQs, use the two-question test: how long is it needed, and does the provider become an owner.
• In case questions, link your recommendation to the matching principle and the firm's risk position.
• Do not state exact costs or rates for sources unless the question gives them.
• Expect theory questions: stages, methods, VC vs PE, or sources for a start-up case. Prepare a standard two-column comparison.
• In case questions, always state the stage before recommending a source. This earns the reasoning marks.
• For MCQs, pick the option that matches risk logic: early stage means equity-like, no collateral, high risk.