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ACCA Applied Skills · Financial Management

Sources of Finance and Their Relative Costs in ACCA Financial Management

Sources of finance are the ways a company raises long-term and short-term money: equity, debt, hybrids, leasing and others. Each has a cost that investors require. You calculate each cost, weight it by market value, and combine them into the weighted average cost of capital (WACC) to use as a discount rate.

What this chapter covers

This chapter covers where a company gets its money and what that money costs. You start with the main sources: equity and share issues, bonds and loan notes, preference shares and convertibles, leasing, short-term finance, venture capital and Islamic finance. For each one you need to know the features, the risks to the company and the investor, and when it suits a business.

The second half is calculation. You find the cost of equity using the dividend valuation model and the capital asset pricing model (CAPM). You find the cost of debt using the internal rate of return on market price, interest and redemption value, adjusted for tax. You then do the same for preference shares and convertibles. Finally you combine everything into the WACC, using market values as weights.

This chapter feeds much of the rest of FM. WACC is the usual discount rate in investment appraisal (NPV), and the cost of capital links to business valuation, capital structure and risk. Questions can appear in Section A, in Section B cases and in the 20-mark Section C questions, often as one step inside a longer calculation.

Cost of capital is a building block for investment appraisal and valuation, so an error here carries into later marks. The chapter mixes short objective questions on features of finance with calculations that are easy to practise and score on. Objective questions are all or nothing, so precise formulas and correct use of market values matter. In constructed-response questions you also earn marks for sensible advice on which source of finance suits a company, so both the numbers and the discussion are worth your effort.

Sources of finance and their relative costs: topics in the order to study them

  1. 1Equity Finance and Share IssuesEquity is the base of every capital structure, and rights issues and other share issues come up in both discussion and calculation.
  2. 2Debt Finance, Bonds and Loan NotesDebt is the second main source, and you need its features and security terms before you value or cost it.
  3. 3Hybrid Finance and Convertibles, Preference SharesThese sit between debt and equity, so they make sense once you know both.
  4. 4Leasing and Short-Term Finance SourcesThis covers asset and working capital funding, including lease or buy decisions, and builds on your knowledge of debt.
  5. 5Venture Capital, Islamic Finance and Other SourcesThese are narrower sources, mainly tested through features and suitability, so they come after the core ones.
  6. 6Cost of Equity: Dividend Valuation and CAPMYour first calculation topic: equity is the highest-cost source and the hardest to measure, so learn it before the others.
  7. 7Cost of Debt, Preference Shares and ConvertiblesUses the return an investor gets on a security, with tax effects, and builds on the valuation ideas from equity.
  8. 8Weighted Average Cost of Capital (WACC)The final step combines every individual cost using market value weights, so study it last.

How to prepare Sources of finance and their relative costs

Split your preparation into knowing the sources and doing the calculations. The first is learning and comparing, the second is practice.

  1. Make a one-page comparison table for each source: who provides it, cost, risk, security, tax treatment and typical use. Rebuild it from memory until it is automatic.
  2. Learn each formula with its conditions, such as when the dividend growth model applies and what the CAPM inputs mean. Write them on a revision card.
  3. Practise cost of equity with both models until you can state which inputs you need and where they come from in the question.
  4. Practise the cost of debt as an IRR using interpolation. Use the post-tax interest rate, and be clear on what redemption value and market price are.
  5. Do full WACC questions using market values, not book values, for both equity and debt. Check the weights add to 100%.
  6. Finish with mixed questions that ask you to calculate and then advise on a source of finance, so you practise both the numbers and the written answer. Review every wrong answer and note the cause.

Common mistakes in Sources of finance and their relative costs

  • Using book values instead of market values as WACC weights.

    Fix: Take market values for equity and debt whenever the question gives them, and show the weights clearly.

  • Forgetting tax relief on debt interest or applying it to preference dividends.

    Fix: Ask whether the payment is tax-deductible. Debt interest is, preference dividends are not.

  • Using the wrong share price in the dividend model, such as a cum-dividend price or an old dividend.

    Fix: Check the price is ex-dividend, and grow D0 by (1 + g) to get next year's dividend.

  • Mixing up the CAPM inputs, for example using the market return as the risk premium.

    Fix: Underline what the question gives. If it gives the premium, use it directly. If it gives Rm, subtract Rf first.

  • Writing generic advice on sources of finance that ignores the company in the scenario.

    Fix: Link each point to the facts: size, gearing, security available, listing status and the purpose of the funds.

Last-day revision: Sources of finance and their relative costs

  • Rights issue: new shares offered to existing shareholders in proportion, usually at a discount to market price.
  • Equity is riskier for investors than debt, so it has a higher required return.
  • Interest on debt is usually tax-deductible, so cost of debt is calculated after tax.
  • Dividend valuation model with growth: Ke = D0(1 + g) ÷ P0 + g, where P0 is ex-dividend price.
  • CAPM: Ke = Rf + β × (Rm − Rf).
  • Irredeemable preference share cost = dividend ÷ market price; there is no tax adjustment.
  • Cost of redeemable debt is the IRR of the cash flows: price now, post-tax interest, redemption value.
  • Convertible: compare the redemption value with the conversion value, and use the higher in the cost calculation.
  • WACC = Σ (market value weight × cost of each source).
  • Use market values for weights, not book values, where they are given.
  • Leasing: operating leases keep the asset with the lessor; finance leases pass most risks and rewards to the lessee.
  • Match the finance to the need: long-term assets with long-term finance, working capital with short-term finance.

Sources of finance and their relative costs practice questions

Sources of finance and their relative costs in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Sources of finance and their relative costs: frequently asked questions

Which formulas in this chapter must I learn?

You need the dividend valuation model and the cost of debt and WACC approach, and you should know how to apply them. CAPM and WACC are usually given on the formulae sheet, but you still must know what each input means. Check the exam's provided sheet when you practise.

Do I use book value or market value in WACC?

Use market values wherever they are available. Market value reflects what investors currently require. Use book value only when the question gives nothing else.

Is cost of debt always calculated after tax?

Usually, because interest is generally tax-deductible. Follow the question: if it says tax relief is available, adjust. Preference dividends are not tax-deductible, so no adjustment applies to them.

How is this chapter tested in the exam?

Features of finance sources are tested in objective questions. Cost calculations and WACC appear in objective cases and as steps within the longer written questions. Remember that objective questions give no partial marks, so accuracy matters.