CHAPTER FIVE

SOURCES OF FINANCE
There are generally three liability areas of the government. These are public debt
administration, risk management and personnel benefits, mostly pensions. Public debt is the
result from private individuals and financial institutions with the promise of paying back the
money borrowed plus interest.
The common purposes of public debt are:
1. Managing the national economy,
2. Making expenditures that exceed revenues over a long term period,
3. Making expenditures that exceed revenues over a short term period,
4. Financing specific large expenditures over a period of time, usually capital
expenditures.
The sources of finance to the government depending on the time period can be generally
classified as short term and long term.
5.1. Short-Term Financing
Short term financing refers to various external financing sources incurred by the government
that are payable within one year. They appear as current liabilities on a government’s
balances sheet. Some of the sources of short term financing include accounts payable,
accruals, bank loans, certificates or notes sold or transferred to banks or other investors, cash
discounts and unpaid bills and claims. It is most frequently used to smooth out irregularities
between expenditures and income flows and to finance current operations on a temporary
basis during periods when tax or other receipts fall of unexpectedly.
A. Accruals
Accruals are unpaid claims. They include expenses incurred but not yet paid. It is an
equivalent to a free loan as there is no interest payment. It is a means of finance until the
amount is paid.
B. Trade Credits
It is in the form of accounts payable that usually emerges from purchasing materials, supplies
and equipment. The duration of funds available for use depends on the credit period.
C. Cash Discounts
Cash discount is a percentage deduction from the purchase price if the payer pays within a
specified time that is shorter than the credit period.
An important decision making area regarding the trade credit is to choose between taking the
discount or forgiving the cash discount attached to credit purchase.
Cost of giving up cash discount is:

C= D% X 360
1- D% Cr. Period – D Period

Example:
Addis town Municipality purchased equipment for Birr 100,000 with credit terms 2/20, n/50.
The Finance Manager wants to decide either to take or the cash discount or forgive it.
Required:
 1. What is the cost of giving up the cash discount?
2. If the buyer can stretch the credit by 20 days, what will be the cost of capital?
3. Should the buyer take the cash discount if the existing interest rate is 20%?
4. What do you recommend if the credit period is reduced by 10 days?

D. Bank Loans
Two types of agreements are usually made for obtaining short term bank loans.
1. Line of credit
A line of credit is an informal agreement by the bank to lend up to a stated maximum amount.
The bank doesn’t have any legal commitment however, and charges interest only for the
amount borrowed.
2. Revolving credit
A revolving credit is a line of credit with a legal commitment of the bank to lend up to the
maximum. The bank will charge a nominal fee for the unused portion of the agreed amount,
in case the borrower doesn’t use the amount in full.

Banks may require the borrowers under a line of credit to maintain a minimum average
amount with the bank or pay a fee for the service. The minimum amount required is called
Compensating Balance, which will have an effect on borrowings.
Example:
Educational materials production Enterprise requests for a loan of Birr 2,400,000 from the
Commercial Bank of Ethiopia. The bank requires a compensating balance of 10% and
charges interest rate of 8%.
Required:
1. What is the effective rate of interest?
2. If the same amount can be borrowed from Dashen Bank with a compensating balance
of 8% and interest rate of 10%, which loan is recommended?
3. If the enterprise is in need of a net amount of Birr 900,000 from CBE, how much
should it request?

Amount to be borrowed = Amount Required

1 - Compensating Balance

4. Assume that the amount of loan of Birr 240,000 is for a period of 180 days. Calculate
the effective rate.

ER = I x 360 Days
P-CB Days Loans Outstanding

I = Birr 240,000 x 0.08 x 180 = 9600

360
ER = Birr 9600 x 360 = 8.89%
180
Discounted Loans

If the bank deducts the interest in advance, the Effective rate of interest will increase.

Eg. Assume that Birr 240,000 is borrowed @ 10% discounted with a compensating balance
of 20%. Calculate the effective rate.

ER (effective rate) = Interest

P–C–D

= 24,000 = 14.29%
240,000-48,000-24,000

5.2. Long-Term Financing

A long term financing is appropriate under the following conditions:
 Where the project is of a type that will not require replacement for many years such as
a city hall, major health facility, or sewage disposal plant.
 Where the project can be financed by service charges to pay off the debt
commitments.
 Where needs are urgent for public health and safety purposes or other emergency
reasons.
 Where intergovernmental revenues may be available on a continuous basis to
guarantee the security of the debt.
 For financing projects in areas of rapid expansion where the demand on local tax
resources are comparatively large and unforeseen.
Long-term financing sources could be:
I. Equity financing,
II. Debt financing,
III. Lease financing.
I. Equity Financing
Equity securities are capital stocks, which represent shares. The two forms of equity
securities are common stock and preferred stock. These two forms of securities are not
common in government organizations. However, few public enterprises may issue stocks to
raise funds.
II. Debt Financing
The most common method of financing government entities is debt financing. Government
organizations issue bonds to raise long-term funds. Bond is a promissory note ensuring that
the lender will receive periodic payments of interest and at maturity repayment of the original
sum invested. The face value of the bond is the amount that the issuer of the bond pays the
bondholder at maturity. Coupon rate is the annual rate of interest on the face value of the
bond that the issuer agrees to pay the bondholder until maturity.
Types of bonds
Bonds can be issued on either an unsecured or secured (asset-backed) basis. Unsecured bonds
are bonds that are issued without pledging collateral. Some examples of unsecured bonds
include debentures and income bonds. On the other hand, secured bonds are bonds where
fixed assets are used to secure their issuance. The most common type of secured long-term
debt instrument is mortgage bond.
Various types of bonds are issued by the govt’s, depending on their needs. The government
has to decide the terms and conditions of the bonds. One of the most common types of bond
is General Obligation Bonds which are backed by the “full faith, credit and taxing power” of
the issuing authority. For many investors, general obligation bonds are seen as the most
secured because the issuing authority has the power to levy taxes at a level necessary to meet
debt service requirements. In effect, the security of these bonds is based on the economic
resources of taxpayers.
1. Special Tax or Special Assessment Bonds: are payable only from the proceeds derived
from a special tax (such as highway bonds payable from a gasoline tax) or from a special
assessment levied against those who benefit from the facilities constructed (e.g special
assessment for gutters in certain residential areas). Special benefit assessments place a
major share of the burden of financing on those individuals or properties receiving the
greatest benefits from improvements.
2. Revenue bonds: are obligations issued by the government agencies to finance a
revenue-producing enterprise such as the construction of a toll road or bridge. Both the
principal and interest of such bonds are paid exclusively from the earnings of the
enterprise.
3. Stepped Coupon Bonds: - in traditional serial bonds, each maturity has a single coupon
rate payable over the life of the bond. Stepped coupon bonds use a serial maturity
schedule, with coupon rates that start at lower levels and progressively increase to higher
levels, even though all the bonds in the issue are sold at par. The increase in coupon
payment each year is intended to provide a hedge against inflation. The issuing
government may schedule more bonds to mature in early years because of the lower
coupon rate, thereby lowering the average life of issue.
4. Zero-Coupon bonds: are not eligible for any interest, but sold at a deep discount. This is
a tax-saving type.
5. Capital appreciation Bonds: that are also called compound interest bonds, are sold at par.
The interest is held by the issuer and compounded at a stated rate so that the investor
receives a lump sum, on maturity.
6. Tender option bonds: also known as put bonds, after the investor the option of submitting
the bond for redemption before maturity. In return for this option, the investor accepts a
lower yield.
7. Flexible Interest Bonds: the yield on these bonds changes over the life of the bond based
on some interest index issued by reliable authorities.
8. Detachable warrant bonds: give the holder the right, at some future date, to purchase
more of the same securities to which the warrant is attached, at the same price and rate of
return as the original bond. In return, the issuer pays a lower rate of interest.
9. Inflation protection bonds: pay a lower stated rate of return in exchange for a guarantee
that the buyers will not reduce the buying power only by inflation. The principal amount
of these bonds will be adjusted for inflation while the interest rate remains fixed.
III. Lease Financing

An entity's non-financial assets can be acquired either through outright purchase or leasing
arrangements. When leasing an asset the entity only pays for the use of the asset over the
term of the lease and ownership of the asset does not pass to the entity at any stage unless the
lease contract specifically states it. Leases where substantially all the risks and rewards
incidental to ownership are transferred are usually classified as finance leases. When buying
an asset, the entity pays the full cost of the asset at acquisition date and has full ownership
over the asset.
Lease purchases have been used to finance the acquisition of equipment, such as computers,
motor vehicles, and more recently, long term projects, such as the acquisition of real
property. In a lease purchase agreement, a government acquires an asset by making a series
of lease payments, which are considered installments toward the purchase of the asset. The
government may obtain title to the asset at the end of the lease term. A lease is a contract that
enables the lessee to secure the use of a tangible asset over a specified time by making
periodic payments to the owner.

A financial lease is recorded as an asset when the transaction (contract) is entered into and,
similar to the outright purchase option, will give rise to depreciation expense as would be the
case of other assets controlled by the entity. If there is no reasonable certainty that the lessee
will obtain ownership by the end of the lease term, the asset is required to be fully
depreciated over the lease term or its useful life, whichever is shorter.

An operating lease on the other hand, will usually specify a period over which an entity will
have the right to use the goods, and have them replaced if they stop working during the lease
period, but will then return the goods to the lessor at the end of the lease. Operating or service
leases are short-term leases whereas Financial or Capital leases are long term leases.
Operating Lease usually contains a clause of cancellation and provision for repair and
maintenance by the lessor. Financial leases are not usually cancelable and contain provisions
for repair, services tax, and insurance by the lessee.

The best way to make a fair comparison between the cost of acquiring the asset through
purchase and the cost of acquiring it through a lease involves calculating the NPV of the cost
to buy the asset by including all the relevant cash flows. Then, NPV of the cost to leasing the
asset is calculated by considering all relevant cash flows such as periodic lease charge which
is not considered in purchase option. Finally, the decision is made by selecting the option
which results in higher NPV.
Example (Lease or Buy Decisions)
An NFP organization is trying to decide on buying a vehicle or leasing it. The estimated
increase in annual revenue is Birr 20000 and in operating expense is Birr 9000; regardless of
the decision. The vehicle costs Birr 30000 with an estimated life of 5 years and salvage value
of Birr 5000. An annual lease payment of Birr 5000 is required for leasing the asset. Straight
line method is the accepted depreciation method. Discount rates are 10% for purchased
equipment and 7% for leased equipment. The organization is not a taxpaying institution.
Should the asset be purchased or leased?
5.3. Cost of Capital
From the viewpoint of the private sector, cost of capital is the minimum rate of return that a
firm will accept on certain capital budgeting projects. It is determined on the basis of the
components of the capital such as borrowed capital (bonds), preferred stock and common
equity including retained earnings. Cost of capital is the total of the cost of each component
of capital. It is used in investment, financing and pricing decisions.
Cost of Capital in the Public Sector
Considerable debate exists as to the choice of an appropriate cost of capital in the public
sector. Since a well-accepted model is not available for deciding the desirability of projects,
a number of possible discount rates are used for taking investment decisions. However, there
are two main approaches to solve this problem.
1. Social Opportunity Cost Rate.
Insofar as funds used for public sector comes from the private sector, it can be argued that
they have displaced either current consumption or investment by private individuals and
businesses. To the extent that private sector investment is displaced, the concept of a social
opportunity cost has been developed. This is defined as the pre-tax rate of return in the
private sector. i.e. the rate of return the funds would have yielded for society had they not
been commandeered by the public sector.
2. Social Time Preference Rate
To the extent private consumption is displaced, it is argued that the social time preference
rate is the relevant concept. This is defined as the after tax rate of return required by society
to induce it to sacrifice present consumption for the promise of future consumption as
generated by the investment. The social time preference rate will depend, among others, on
factors such as the age structure of the population, which will change over time, expectations
about the growth in prosperity, and the general level of prosperity etc. There is an obvious
discrepancy between the social time preference rate and the social opportunity cost rate as
one is before tax and the other is after tax rate. Some of the public organizations that are
constantly in touch with the markets may use market interest rates as the cost of capital.
Where a combination of sources of finance is used, the organization should compute a
weighted cost of funds.
Financial experts differ in their views regarding the cost of fund capital in NFP organizations.
Their most important positions are as follows:
 The Fund Capital has a zero cost because the donors to NFP organizations do not expect a
monetary return on their contributions.
 The second position also assumes zero cost, but requires that fund capital must earn a
return sufficient to enable the organization to replace existing assets as they wear out.
 The third position is that fund capital has some cost but not very high. The fund capital
may be invested in marketable securities and the cost of capital is roughly equal to the
return available from low-risk, short term securities.
 The final position is that fund capital has about the same cost as the cost of retained
earnings to similar investor-owned firms.
Some of the NFP organizations are completely exempted from tax. In such a case, there is no
tax effect associated with debt financing.
5.4 Financial Leverage in the Public Sectors
Financial leverage reflects the amount of debt used in the capital structure of an organization.
Because debt carries a fixed obligation of interest payments, we have the opportunity to
greatly magnify our results at various levels of operation. Operating leverage affects the left
hand side of a balance sheet whereas financial leverage affects the right hand side.
We shall examine two financial plans for an organization each employing significantly
different amount of debt in the capital structure.
Assume, Total Assets = Birr 80,000

Plan A (leveraged) Plan B (conservative)

Debt @10% 20,000 (2000 interest)
60,000 (6000 interest)
Common Stock 2000@10 (20,000) 6000@10 (60,000)
Tax 50% 50%
We shall check the change in earning per share (EPS) at different levels of EBIT.
Lev Cons Lev Cons Lev Cons Lev Cons
EBIT 5000 5000 10000 10000 25000 25000 50000 50000
Int. exp 6000 2000 6000 2000 6000 2000 6000 2000
EBT (1000) 3000 4000 8000 19000 23000 44000 48000
Tax - 1500 2000 4000 9500 11500 22000 24000
EAT (1000) 1500 2000 4000 9500 11500 22000 24000
shares 2000 6000 2000 6000 2000 6000 2000 6000
EPS - 0.25 1 0.67 4.75 1.92 11 4

5.4.1 Degree of financial leverage

Degree of financial leverage is defined as the percentage change in EPS that takes place as a
result of the percentage in EBIT.

DFL = Percentage change in EPS

Percentage change in EBIT

DFL = EBIT
EBIT-I
DFL of a conservative organization at an EBIT of Birr 50000:
DFL = 50000 = 1.04
50000-2000
When one percentage change takes place in EBIT, 1.04% change takes place in the EPS.
DFL of the leveraged organization at an EBIT of Birr 50000:

DFL = 50000 = 1.14

50000-6000
When 1% increase is there in EBIT, 1.14% increase will take place in EPS.