IAI Actuarial Core Principles · Business Finance
Structure and Methods of Financing a Company
This chapter covers how a company raises money: retained profits, new shares, debt, hybrids and leases. You then study how the mix (capital structure, gearing) affects risk and the cost of capital, measured by WACC. Solve questions by naming the source, stating its cost and risk, and linking it to the company's situation.
What this chapter covers
This chapter explains where a company gets its long-term money and what each source costs. You start with the split between internal finance (retained profits, depreciation funds) and external finance (new equity, borrowing). You then study each source: ordinary and preference shares, rights and bonus issues, bonds, loans, debentures, convertibles, warrants and leases.
The second half moves from individual sources to the whole mix. Capital structure is the proportion of debt and equity. Gearing measures how much of the financing is fixed-return debt. WACC combines the cost of each source, weighted by its share of the total, into one required return for the company.
This chapter feeds the rest of CB1. Project appraisal uses the cost of capital as the discount rate. Company accounts show how financing appears on the balance sheet and in the income statement. Corporate governance links to the rights of shareholders and lenders. In CB2 and CM2 you will meet related ideas on risk, returns and valuation, so a clear grasp here pays off later.
The syllabus weighting for CB1 gives 'How corporates are financed' the largest share of any topic area, at 35%. That makes this chapter the most valuable one in the paper. It also supports the project evaluation and accounts sections, so weak understanding here costs marks in several places. Questions mix multiple-choice recall with written questions that ask you to compare sources, advise a company or calculate a cost of capital. You need both the definitions and the reasoning.
Structure and methods of financing a company: topics in the order to study them
- 1Sources of Corporate Finance: Internal vs ExternalIt gives you the map of all sources, so every later topic has a place to sit.
- 2Equity Financing and Share IssuesEquity is the base of every capital structure, and you need its rights and issue methods first.
- 3Debt Financing: Bonds, Loans and DebenturesDebt is the main contrast to equity, and gearing makes no sense without it.
- 4Hybrid Finance, Leasing and Other MethodsHybrids borrow features from both equity and debt, so learn them after you know each side.
- 5Capital Structure and GearingNow you combine the sources and study how the mix changes risk and return for shareholders.
- 6Cost of Capital and WACCIt is the numerical finish: you need every source and the structure before you can weight their costs.
How to prepare Structure and methods of financing a company
Build the chapter in layers: first descriptions, then comparisons, then calculations. Short daily sessions work well if you study on your phone alongside work.
- Make a one-page table of all sources. For each, note who provides it, its cost, risk to the company, control effects and tax treatment.
- For equity and debt, learn the key features in your own words, such as ranking on winding up, fixed or variable returns and security.
- Practise comparison answers: given a company's situation, choose a source and give two reasons for and two against.
- Learn the definition of gearing in its common forms and calculate each from a simple balance sheet, stating which measure you use.
- Work through WACC step by step: find the market value of each source, compute its weight, apply the after-tax cost of debt, then add the weighted costs.
- Do past-paper MCQs on this chapter and review every wrong answer against your table.
- In the last week, rewrite your table from memory and check the gaps.
Common mistakes in Structure and methods of financing a company
Treating retained profits as a free source of finance
Fix: State that shareholders have an opportunity cost, and that retained profit carries a cost of equity.
Mixing up rights issues and bonus issues
Fix: Remember that a rights issue raises cash and a bonus issue does not.
Using the pre-tax cost of debt in WACC
Fix: Adjust for tax first, if interest is deductible, and say so in your working.
Using book values for weights without checking the question
Fix: Use market values if given, and state the assumption if you must use book values.
Quoting one gearing ratio without defining it
Fix: Write the formula you use, such as debt ÷ (debt + equity), then apply it consistently.
Giving a list of features instead of advice
Fix: Tie each point to the company in the question: its size, risk, tax position and need for control.
Last-day revision: Structure and methods of financing a company
- Internal finance: retained profits and depreciation. External finance: new shares, loans, bonds, leases.
- Retained profits are not free: shareholders expect a return on them.
- Ordinary shareholders are paid last on winding up and carry the most risk.
- A rights issue offers new shares to existing shareholders in proportion to their holdings, usually at a discount.
- A bonus issue turns reserves into shares and raises no new cash.
- Debt interest is usually tax-deductible, which lowers its after-tax cost.
- Secured debt ranks ahead of unsecured debt if the company fails.
- Convertibles and warrants are hybrids linked to future equity.
- A finance lease transfers most risks and rewards of ownership to the lessee; an operating lease does not.
- Higher gearing raises the risk of financial distress and makes equity returns more volatile.
- WACC = weighted sum of each source's cost, using market value weights where possible.
- Use the after-tax cost of debt in WACC when interest is tax-deductible.
Structure and methods of financing a company practice questions
- Shree Textiles Ltd needs Rs 50 crore. Its profit after tax is Rs 40 crore and it normally pays out 60% as dividends. It has no spare cash. I…
- Which of the following is the most significant internal source of long-term finance for an established, profitable Indian manufacturing comp…
- Which of the following best explains why, for a profitable company, the cost of debt used in the WACC is normally taken after tax?
- A firm with high operating gearing and high financial gearing experiences a fall in sales. Which statement best describes the effect on shar…
- Sundaram Textiles Ltd has issued a 10-year bond with a face value of Rs 1,000 and a coupon of 8% per annum paid annually. Market yields for …
- Which feature most clearly distinguishes a sale and leaseback from a conventional lease of a newly bought asset?
- A listed company offers its existing shareholders the right to buy new shares in proportion to their current holdings, at a price below the …
- Kaveri Ltd has a risk-free rate of 6%, an expected market return of 12% and an equity beta of 1.5. It has debt of Rs 30 crore (pre-tax cost …
Structure and methods of financing a company in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Structure and methods of financing a company: frequently asked questions
How important is this chapter for CB1?
The syllabus weights 'How corporates are financed' at 35%, the highest of the four areas. Expect it in both the multiple-choice and written parts. It also underpins project evaluation and accounts questions.
Do I need to memorise WACC calculations?
You should know the method, not just the result. Show each weight, each cost and the final sum. Examiners reward clear working and stated assumptions.
What is the difference between internal and external finance?
Internal finance comes from within the business, mainly retained profits. External finance comes from outside, such as new shares, loans, bonds or leases.
How should I answer a 'which source should the company use' question?
Look at the company's size, existing gearing, tax position, need for control and the purpose of the funds. Then compare two or three sources with reasons for and against, and give a clear recommendation.