Sources of Finance: formula sheet

Key formulas

Classification by period

Short term: up to 1 year | Medium term: above 1 year to about 5 years | Long term: above 5 years

Usual convention. Use the limits given in the question if they differ.

Classification by ownership

Owned funds = equity capital + retained earnings + reserves | Borrowed funds = debentures + loans + deposits + trade credit

Preference capital is treated as owned in law but works like fixed-cost finance, so state your view.

Classification by source

Internal = retained earnings, depreciation provision | External = shares, debentures, loans, creditors

Internal sources need no outside approach, so there is no issue cost.

Matching principle

Long-term assets ← long-term finance | Current assets ← short-term finance

A mismatch raises risk or cost.

Rights issue: theoretical ex-rights price

Ex-rights price = (N × Cum-rights price + R × Issue price) ÷ (N + R)

N = old shares held for the offer; R = new shares offered against them. Use the market price just before the issue as cum-rights price.

Value of a right

Value of right per new share = Cum-rights price − Ex-rights price (with one new share offered per right)

For the value per old share held, divide the total gain by N old shares. State clearly which one you compute.

Bonus issue accounting

Bonus capitalised = Number of bonus shares × Face value

Debit free reserves or securities premium, credit equity share capital. Net worth stays the same.

Ex-bonus price (approximate)

Ex-bonus price = Cum-bonus price × Old shares ÷ (Old shares + Bonus shares)

Assumes market capitalisation does not change. It is a theoretical estimate.

Preference dividend

Preference dividend = Rate × Face value × Number of shares

For cumulative shares add arrears for the years missed.

Sweat equity discount

Discount = Fair value of share − Issue price

The discount is the benefit given to the employee for contribution made.

Annual interest on a debenture

Interest = Face value × Coupon rate

Interest is on face value, not on issue price or market price.

Issue at discount or premium

Issue price = Face value − Discount, or Face value + Premium

Net proceeds also fall by issue costs. Interest is still on face value.

Post-tax interest cost (simple view)

Post-tax interest = Interest × (1 − Tax rate)

Applies when the company has taxable profits against which interest can be deducted.

Redemption value of a debenture

Redemption value = Face value (+ Premium on redemption, if any)

Convertible debentures are instead exchanged for shares at a stated conversion ratio.

Number of shares on conversion

Shares received = Debentures held × Conversion ratio

Conversion ratio is the number of shares per debenture, as stated in the terms of issue.

Retained earnings for the year

Retained earnings = Profit after tax − Dividends (equity and preference)

Add this amount to the opening balance of reserves and surplus to get the closing balance.

Retention ratio

Retention ratio = Retained earnings ÷ Earnings available to equity shareholders = (Earnings available to equity − Equity dividend) ÷ Earnings available to equity

Earnings available to equity = Profit after tax − Preference dividend. Retained earnings here are after both dividends, so the numerator equals earnings available to equity less equity dividend. If there is no preference dividend, this equals Retained earnings ÷ Profit after tax. Show as a fraction or percentage.

Dividend payout ratio

Payout ratio = Equity dividend ÷ Earnings available to equity; Retention ratio = 1 − Payout ratio

Use equity dividend only, not preference dividend. The two ratios then add up to 1 (or 100%).

Cash generated internally (simple view)

Internal cash = Retained profit + Depreciation (and other non-cash charges)

Use this only when the question treats profit as cash. Check for working capital changes.

Cost of foregoing cash discount (simple)

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

Use credit period and discount period in days. Example: 2/10 net 30. Use 360 days if the question says so.

Effective cost of foregoing discount (compound)

[1 + Discount % ÷ (100 − Discount %)]^(365 ÷ (Credit period − Discount period)) − 1

Use only when the question asks for the effective or compounded rate.

Cost of discounted instrument (CP, bill)

[Discount ÷ Net amount received] × [365 ÷ Days to maturity] × 100

Add issue costs and fees to the discount. Net amount = face value − discount − fees.

Discount on a bill or CP

Discount = Face value × Rate % × Days ÷ 365

Follow the day-count given in the question.

Factoring advance

Advance = (Receivables − Factor reserve) − Factoring commission − Interest on advance

Reserve is a retained percentage. Interest is charged on the advance, often for the credit period.

Net benefit of factoring

Savings (collection cost, bad debts, interest on lower receivables) − Factoring commission − Extra interest

Accept factoring when net benefit is positive, or compare the effective cost with the bank rate.

Finance lease vs operating lease

Finance lease: long term, non-cancellable, lessee bears risks | Operating lease: short term, cancellable, lessor bears risks

Classify by who carries the risks and rewards of ownership, not by the name in the agreement.

Lease rental (annual, level)

Annual lease rental = Cost of asset ÷ Present value annuity factor (at the discount rate for the lease term)

Use this when a lessor is asked to find the rental that recovers cost and return. Ignore residual value unless given.

Net advantage of leasing (NAL)

NAL = Asset cost − PV of after-tax lease rentals − PV of foregone depreciation tax shield − PV of foregone salvage value (after tax, if any)

After-tax lease rental = Rental × (1 − tax rate). Foregone depreciation tax shield = Depreciation × tax rate, lost each year because the lessee does not own the asset. If NAL is positive, lease. If negative, buy. If the loan route is used, discount at the after-tax cost of debt unless told otherwise.

After-tax cost of debt

Kd (after tax) = Interest rate × (1 − tax rate)

Standard discount rate in lease versus buy comparisons.

Hire purchase interest

Total interest = Total of instalments paid − Cash price

Interest is usually charged on the outstanding balance, so each instalment has an interest part and a principal part.

Conversion value of a convertible

Conversion value = Market price per equity share × Conversion ratio

Compare with the straight-debt value to decide whether conversion is attractive.

Conversion ratio of an FCCB

Conversion ratio = Face value of bond ÷ Conversion price

Gives the number of shares per bond. Convert the face value into the same currency as the conversion price first.

Conversion value

Conversion value = Conversion ratio × Current market price per share

Compare with the bond's face value or market price to judge whether conversion is worthwhile.

Conversion premium

Conversion premium per share = Conversion price − Current market price

Percentage premium = Premium ÷ Current market price × 100.

Rupee cost of a foreign-currency loan

Rupee repayment = Foreign-currency amount × Exchange rate at repayment

A weaker rupee raises the rupee outflow, so effective cost exceeds the stated coupon.

Effective rupee cost of foreign loan (approx.)

(1 + r) × (1 + d) − 1, where r = foreign interest rate and d = rate of rupee depreciation

Use the compounded form when the question gives both the rate and expected depreciation.

Quick revision

• Classify sources by period (short, medium, long), ownership (owned or borrowed) and origin (internal or external).
• Equity shareholders are owners, bear the highest risk and get dividends only when declared.
• Preference shares carry a fixed dividend and a preferential claim over equity on dividend and repayment.
• Debenture interest is a fixed charge and is tax-deductible for the company, unlike dividends.
• Debt does not dilute control but raises financial risk because interest must be paid.
• Retained earnings need no issue cost and no new shareholders, but they are not free of cost.
• Trade credit is a spontaneous short-term source that arises from normal business dealings.
• Working capital sources are matched to short-term needs, not used to buy long-term assets.
• Venture capital funds young, high-risk businesses in return for an equity stake.
• In a lease, the lessor owns the asset and the lessee pays rentals for using it.
• Foreign sources bring wider funding but add exchange rate risk.

Common mistakes

• Calling retained earnings an external source. Fix: Retained earnings are profits kept in the business. They are internal and owned.
• Treating all debentures as short-term. Fix: Debentures normally run for several years, so they are long-term, borrowed and external.
• Saying bonus shares bring cash into the company or increase shareholder wealth. Fix: Remember bonus is a book entry from reserves to capital. Net worth and total market value stay the same; only the number of shares changes.
• Treating preference dividend as an expense that saves tax. Fix: Preference dividend is an appropriation of profit after tax. Only interest on debt is deductible.
• Saying debenture holders are owners of the company. Fix: Remember that debenture holders are creditors. They lend money, earn interest and have no voting rights.
• Calculating interest on issue price or market price. Fix: Interest always uses face value and the coupon rate. The issue price only affects the cash received.
• Saying retained earnings are free of cost. Fix: Say there is no explicit cost but an opportunity cost, equal to the return shareholders expect on the funds.
• Treating depreciation as a source that creates new funds. Fix: Explain that depreciation is a non-cash expense. It retains cash already earned from operations and does not bring in fresh money.
• Dividing the discount by the face value instead of the net amount received. Fix: Divide by the amount actually received after discount and fees, since that is the money you can use.
• Using the full credit period instead of credit period minus discount period in the foregone-discount formula. Fix: The extra days you gain by not paying early are credit period − discount period. Use that gap.

Exam tips

• For a 'classify' question, write the basis as a heading word, then list sources under it with a short reason. Reasons earn the marks.
• In MCQs, watch the wording. 'Internal' and 'owned' are different tests, and a source can pass one and fail the other.
• Where a question asks for suitability, always mention the matching principle and one risk.
• Use the period limits stated in the question. If none are stated, say 'generally' before giving the usual limits.
• Learn two or three examples for each class so that you can write quickly in a descriptive answer.
• Differences between equity and preference shares are asked often. Prepare a table with at least six points and learn it.
• In short notes on rights, bonus or sweat equity, write meaning, purpose, effect on control and one limitation.
• For numericals, always show the formula and substitute values. Step marks are given even if the final answer slips.