Section A

Each question carries 1 mark:

1. What do you mean by equity shares?
Ans: Equity shares are those shares which do not carry any special or preferential rights in
respect of payment of annual dividend and repayment of capital.

2. Which funds are directly raised from the public?

Ans: Equity Capital
3. State various sources of long term funds.
Ans: Shares, Debentures, Loans from financial institutions, Retained Earnings

4. State various sources of short term and medium term funds.

Ans: Trade credit, Factoring, Loan from commercial bank

Each question carries 2 marks:

5. If ABC company wants to acquire funds to expand its business, then in this case,
suggest any two sources from where it can avail the required finance?
Ans: (i) By using equity shares
(ii) By using retained earnings

Each question carries 6 marks :

6. How can sources of finance be categorized? Explain in detail.
Ans: Sources of finance can be categorized as (i) Period basis (ii) Ownership basis (iii)
Source of Generation basis
Period basis: On the basis of period, the different sources of funds can be categorized
into three parts. These are long-term sources, medium-term sources and short-term
sources. The long-term sources fulfill the financial requirements of an enterprise for a
period exceeding 5 years and include sources such as shares and debentures, long-term
borrowings and loans from financial institutions. Such financing is generally required
for the acquisition of fixed assets such asequipment, plant, etc.
Where the funds are required for a period of more than one year but less than five years,
medium-term sources of finance are used. These sources include borrowings from
commercial banks, public deposits, lease financing and loans from financial institutions.
Short-term funds are those which are required for a period not exceeding one year. Trade
credit, loans from commercial banks and commercial papers are some of the examples
of the sources that provide funds for short duration..
Ownership basis: On the basis of ownership, the sources can be classified into ‘owner’s
funds’ and ‘borrowed funds’. Owner’s funds means funds that are provided by the

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 owners of an enterprise, which may be a sole trader or partners or shareholders of a
company. Apart from capital, it also includes profits reinvested in the business.

‘Borrowed funds’ on the other hand, refer to the funds raised through loans or
borrowings. The sources for raising borrowed funds include loansfrom commercial
banks, loans from financial institutions, issue of debentures, public deposits and trade
credit. Such sources provide funds for a specified period, on certain terms and
conditions and have to be repaid after the expiry of that period. A fixed rate of interest is
paid by theborrowers on such funds
Generation basis: Another basis of categorizing the sources of funds can be whether
the funds are generated from within the organization or from external sources.
Internal sources of funds are those that are generated from within the business.
External sources of funds include those sources that lie outside an organization, such as
suppliers, lenders, and investors. When large amount of money is required to be raised,
it is generally done through the use of external sources. External funds may be costly as
compared to those raised through internal sources. In some cases, business is required to
mortgage its assets as security while obtaining funds from external sources

Section B
Each question carries 1 mark :
7. Why can commercial papers be issued only by large and creditworthy companies?
Ans: Because it is an unsecured debt

8. How does Trade credit lead to risk of overtrading?

Ans: Availability of trade credit may induce a firm into overtrading which may add to the
risks of the firm.
9. What is the status of debenture holders?
Ans: Debenture holders are the creditors of the company.
10. What type of costs should be considered by a finance manager while making a
Ans: choice for the source of funds?
i. Cost of procurement
ii. Cost of utilizing the funds
11. Out of long term and short term sources of finance, which source should be
Ans: preferred to finance fixed assets?
Long term sources
12. Why there is no tax benefit in case of preference shares?
Ans: Because dividend paid on preference shares are not deductible from profits as expense.

Each question carries 2 marks:

13. What are the preferences given to preference shareholders over equity
Ans: shareholders?
• Preference in payment of dividend
• Preference in compensation at the time of winding up

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 Each question carries 4 marks :
14. As a source of finance, Retained Earnings is better than other sources. Justify.
Ans: A company generally does not distribute all its earnings amongst the shareholders as
dividends. A portion of the net earnings may be retained in the business for use in the
future. This is known as retained earnings. It is a source of internal financing or
self-financing or ‘ploughing back of profits’. The profit available for ploughing back in
an organization depends on many factors like net profits, dividend policy and age of the
organization.
As a source of finance, Retained Earnings are better than other sources because:
(i) Retained earnings is a permanent source of funds available to an organization;
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation
cost;
(iii) As the funds are generated internally, there is a greater degree of operational
freedom and flexibility;
(iv) It enhances the capacity of the business to absorb unexpected losses;
(v) It may lead to increase in the market price of the equity shares of a company

Each question carries 6 marks :

15. What is business finance? Why do businesses need funds? Explain.
Ans: Business finance refers to capital funds and credit funds invested in business. Financing
means making money available when it is needed. Business finance may be defined as
planning, raising, managing and controlling all the money used or capital funds of any
kind used in connection with business.
No one can start a business or run an enterprise without adequate funds. Business
requires capital and finance for the following purposes:
i. Fixed capital requirements: Funds are required to purchase Fixed Assets like
land, building, plant and machinery. This is known as fixed capital requirement
of the enterprise. The funds invested in Fixed asset remain invested in the
business for a long period of time. The fixed capital requirement depends on the
nature of business.
ii. Working capital requirement: Every firm requires funds for its day-to day
operations. This is known as the working capital of an enterprise. These are used
to meet current expenses like salaries, wages, taxes, rent etc.

16. Explain Trade credit and Bank credit as sources of short term finance for business
enterprises.
Ans: Trade credit: It refers to the credit extended by the supplier to the purchaser of goods or
services. It promotes the purchase of goods and services as the purchaser need not make
immediate cash payments if Trade credit is extended. Trade credit are granted only to
customers or traders who are considered to be creditworthy by the supplier.
Merits of Trade credit as a source of short-term finance:

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 (a) Trade credit helps a company to finance the accumulation of inventories for meeting
future increase in sales.
(b) As the trade creditors do not have any rights over the assets of the company, it can
mortgage its assets to raise money from other sources.

Demerits of trade credit as a source of short-term finance:

(a) Easy availability of trade credit can result in overtrading, which in turn increases the
future liabilities of the buyer.
(b) The amount of funds that can be generated through trade credit is limited to the
financial capacity of the supplier or the creditor.
Bank credit:
Bank credit is a loan advanced by a bank to a business firm. The interest charged by the
bank on the loan usually depends on the interest rate prevailing in the economy. The
borrower needs to mortgage assets with the bank to secure the loan.
Merits of bank credit as a source of short-term finance:
(a) Banks maintain secrecy over information related to their customers.
(b) Bank credit provides flexibility to the borrower as the borrower can increase or
decrease the amount of loan according to the business needs.
Demerits of bank credit as a source of short-term finance:
(a) It is difficult to increase the loan.
(b) The terms imposed by banks are often very restrictive—for example, the bank that
has granted a loan may restrict the sale of goods mortgaged to it by the borrower.

17. What is a Commercial paper? What are its advantages and limitations?
Ans: Commercial paper is a credit instrument used by creditworthy firms to obtain short-term
finance for their business. These are unsecured promissory notes, the maturity of which
ranges from 90 to 364 days. They are generally issued to business firms, banks,
insurance companies and pension funds, and their issue is regulated by the Reserve Bank
of India.
Advantages of Commercial Paper
(a) The cost of issuing commercial paper is generally lower than cost of securing
commercial bank loans.
(b) It a highly liquid asset as it can be transferred to anyone at any time.
(c) Companies can invest their surplus funds in commercial paper and earn good returns
on their investment.
(d) They provide a continuous source of finance to firms, as the maturing funds can be
repaid by issuing fresh commercial paper.
Limitation of Commercial Paper
(a) Since commercial paper denotes unsecured securities, they can only be used by firms
that have a strong market position. Therefore, new firms cannot raise money by issuing
commercial paper.
(b) The amount of money that can be raised through commercial paper is limited as it
depends on the availability of funds with buyers at the time of its issue.

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 (c) The maturity period of commercial paper is fixed and ranges from 90 to 364 days.
Therefore, if a firm is unable to redeem its commercial paper on time because of
unavailability of funds, then it cannot extend the time period of the commercial paper.

18 . Differentiate between Equity shares and Preference shares.

Ans: Sr. No Equity shares Preference shares

1. Face Value The face value of equity The face value of Preference shares is
share is generally low. generally high.

2. Dividend The dividend is paid to Preference shareholders get a fixed rateof

equity shareholders after dividend before equity shareholders.
paying dividend to all
preference shareholders.

3. Voting Equity shareholders get No voting rights.

rights all the voting rights in a
company

4. Attraction Equity shares attract bold Preference shares attract cautious and
and adventurous conservative investors.
investors.
5. Risk The equity shareholders The risk involved in preference shares is
are primary risk bearers of relatively less.
the company.

6. Refund of At the time of winding up, At the time of winding up preference shares
capital the equity shareholders get priority over equity shares for refund of
are refunded only after capital.
preference shares are
paid.

19. Differentiate between owner's fund and borrowed funds.

Ans: Owner capital :
1. Meaning: Consist of the amount contributed by owners and their profit reinvested in
business.
2. Permanent: It remains permanent invested.
3. Risk: It carries risk of business.
4. Control: Control rests with providers of owner’s capital.
5. Security: It does not require any asset as security.
6. Reward: Reward is dividend.
7. Priority: Reward is paid after payment of interest on borrowed funds.
8. Nature of return: The rate of dividend may fluctuate year to year.

Borrowed capital :
1. Meaning : It includes funds available in the form of loans or credit

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 2. Permanent: It is not permanent source of investment.
3. Risk: The debts of company are secured.
4. Control: No control rests with providers of borrowed funds.
5. Security: It is backed by security of assets.
6. Reward: Reward is interest.
7. Priority: Payment of interest gets priority over payment of dividend.
8. Nature of return: The rate of interest is fixed on funds.

Section C
Each question carries 1 mark :
20. Equity shareholders are called
a. Executives of the company b. Partners of the company
c. Guardian of the company d. Owners of the company

21. _________ is an example of short term finance.

a. Share b. Trade Credit
c. Debenture d. None of these

22. Commercial papers can be issued only by large and creditworthy companies’
because_________________.
a. It is Fully Secured Debt b. It is protected by the
Government
c. It is an Unsecured Debt d. None of these

23. Internal sources of capital are those that are________________________.

a. generated through issue of shares b. generated within the business
c. generated through loan from d. generated through outsiders such as
commercial banks suppliers

24. Instead of distributing entire profits to the owners in the form of dividend, some
profits are re-invested in business in order to finance future earnings of the
business. This is known as ______________.
a. Ploughing back b Diversion

c. Working capital d Dividend stripping

25. The amount of funds required for purchasing building, plant and machinery is
know as__________________.
a. Working capital b. Authorized capital
c. Fixed capital d. Permanent capital

Each question carries 2 marks :

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26. In terms of tax benefit, which of the two – Preference shares or debentures – will be
Ans: preferred by the organization? Why?
Debentures-as interest paid on them is tax deductible (tax benefit for the company)

27. Because of festival season, Bhuvan Garments received double orders. Advise the
company the various sources of finance, which can be used to raise necessary
finance for this purpose.
Ans: Because of festival season, Bhuvan Garments received double orders. Advise the
company the various sources of finance, which can be used to raise necessary finance for
this purpose.As the company needs finance for short period of time to meet the pending
orders, so common sources of finance are: Trade credit, Banks

Each question carries 3 marks :

28. What advantages does issue of debenture provide over the issue of equity shares?
Ans: Debentures are financial instruments used by companies to raise long-term debt capital.
They imply that the company has borrowed a certain sum of money which it will repay
later to the debenture holders. They are considered as fixed income securities as they
carry a fixed rate of return and are repayable on a certain pre-specified date in the
future.The following are the advantages of issuing debentures over issuing equity shares.
(a) The issue of equity shares denotes the dilution of ownership of a firm. This is
because the equity share holders own specified shares of the company and have voting
rights. In contrast, debenture holders do not have any rights in the company. That is, they
do not enjoy voting rights or any kind of ownership in the firm. Rather, they are only
entitled to a fixed amount as payment. Thus, debentures do not result in any kind of
dilution of ownership of the firm. Thus, issuing debentures is more advantageous for a
firm than issuing equity shares.
(b) In order to issue shares, a company has to incur huge costs. Besides, it has to pay
dividends to its shareholders, which are not tax deductible. On the other hand, a
company receives tax deductions on the interest paid to its debenture holders. Hence,
issuing debentures is advantageous for a firm in terms of low costs.
(c) Debentures carry a fixed rate of return. This implies that irrespective of the profit
earned, the company has to pay only a fixed interest to its debenture holders. On the
other hand, a company that issues shares has to pay dividends to the shareholders, which
varies with the profit—i.e., the higher the profit, the higher will be the dividends. Thus,
companies prefer to issue debentures if they expect to earn higher profits in a year.

Each question carries 6 marks :

29. The directors of a company have decided to set up a new plant at an estimated cost
of Rupees ten crores. State the sources of finance available with their merits.
Ans: Setting up of a plant means funds are required for fixed assets and for long term. Various
sources of long term finance are:
i. Equity shares
ii. Preference shares
iii. Debentures

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 The above sources of funds are beneficial due to the following reasons:
Equity shares:
•Payment of dividend to the equity shareholders is not compulsory. Therefore, there is
no burden on the company in this respect.
•Equity capital serves as permanent capital as it is to be repaid only at the time of
liquidation of a company. As it stands last in the list of claims, it provides a cushion for
creditors, in the event of winding up of a company.
•Funds can be raised through equity issue without creating any charge on the assets of
the company. The assets of a company are, therefore, free to be mortgaged for the
purpose of borrowings, if the need be.
Preference shares:
•Preference capital does not create any sort of charge against the assets of a company.
•Preference shareholders get a fixed rate od dividend before paying dividend to equity
shareholders.
•Preference shareholders do not get voting rights hence it does not affect the control of
the equity shareholders.
Debentures:
•Debentures are fixed charge funds and do not participate in profits of the company.
•Financing through debentures is less costly as compared to cost of preference or equity
capital as the interest payment on debentures is tax deductible.
•Debenture holders do not get voting rights hence it does not affect the control of the
equity shareholders.
30. A company requires funds to meet its working capital. State the sources available
along with their features.
Ans: The common sources of finance available to meet the working capital requirement are:
i. Short term loans from Commercial Banks
ii. Trade Credit
The above sources of funds are beneficial due to the following reasons:
Short term loans from Commercial Banks
• Banks maintain secrecy over information about the borrower.
• Bank credit provides flexibility to the borrower as the borrower can increase
or decrease the loan amount.
• Banks provide funds to firms as and when required.
• No formalities of issue of prospectus etc. are required. So it is very easy and
economical source of funds.
Trade Credit
• Trade credit helps a company to finance the accumulation of inventories for
meeting future increase in sales.
• As the trade creditors do not have any rights over the assets of the company, it
can mortgage its assets to raise money from other sources.
● It is a convenient and continuous source of fund.

31. There are numerous sources of finance and each source has its own merits and
limitations. What are the guidelines which a business enterprise can follow to
decide the best combination of sources?
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Ans: The guidelines which a business can follow to decide the best combination of sources
are:
i. Cost Involved: The Company must find out the cost of procurement and the cost of
utilizing the funds. Both the cost must be less than the benefit which they get by
using that source of fund.
ii. Financial Strength of the firm: If the firm is financially sound then it may prefer
borrowed fund (debentures, bonds) as it will be able to repay the borrowed fund. But
if the firm is not financially stable then it must depend on the owner’s fund securities
(Equity shares)
iii. Form of business organization:
The legal status and form of business organization influences the choice of sources of
funds. For example. Sole proprietor, partnership etc cannot raise money through
share and debentures however Joint stock company prefer issue of shares and
debentures for finance.
iv. Time period: While deciding the sources of finance, the business should consider
time period (duration) for which funds are required. For example for short period-
Trade credit, factoring, short term loans etc are suitable and for long term- shares,
debentures are suitable
v. Control: The risk associated with different sources of finance is to be considered.
For example. Loan is more risky as the payment of Principal and interest is
obligatory however equity shares are less risky because there is no compulsion to
repay in case of loss.
vi. Flexibility: While deciding the source of finance, the flexibility and ease of
obtaining funds should be considered. For example, borrowings from banks and
financial institutions may restrict the flexibility if there are restrictive provisions and
documentation. In such case, business may prefer other sources which are easily
available.
vii. Tax benefit: Interest on debentures is deducted from the total income of the
company before calculating income tax whereas dividend paid on shares is not
deducted from the total income. So if a firm wants to get tax benefit it should issue
debentures, public deposits etc.
viii. Claim over Assets: Some sources of finance mortgage the assets of the firms and
reduce its creditworthiness. For example. Debentures, secured loans. Whereas some
sources such as shares, unsecured loans etc. do not put claim over the assets, hence
result in no reduction in the creditworthiness.

Section D
Each question carries 6 marks :
32. ‘It is a source of internal financing or self-financing. ‘
i. Identify and explain the source of business finance
ii. Discuss its merits and demerits.
i. A portion of the net earnings may be retained in the business for use in the future. This
isknown as retained earnings.
ii. Merits

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 The merits of retained earnings as a source of finance are as follows:
(i) Retained earnings is a permanent source of funds available to an organisation;
(ii) It does not involve any explicit cost in the form of interest, dividend or floatation
cost;
(iii) As the funds are generated internally, there is a greater degree of operational
freedom and
flexibility;
(iv) It enhances the capacity of the business to absorb unexpected losses;
(v) It may lead to increase in the market price of the equity shares of a company.

Limitations
Retained earnings as a source of funds has the following limitations:
(i) Excessive ploughing back may cause dissatisfaction amongst the
shareholders as they would get lower dividends;
(ii) It is an uncertain source of funds as the profits of business are fluctuating;
(iii) The opportunity cost associated with these funds is not recognized by many firms.
This may lead to sub-optimal use of the funds.

33. “It is an acknowledgment that the company has borrowed a certain amount of
money, which it promises to repay at a future date.”
i. Explain two merits and two demerits of source identified.
ii. Name the credit rating agency that gives rating for issue of debentures.
iii. On what basis does this agency gives rating
i. Merits
(i) It is preferred by investors who want fixed income at lesser risk;
(ii) Debentures are fixed charge funds and do not participate in profits of the company;
Limitations
(i) As fixed charge instruments, debentures put a permanent burden on the earnings
company. There is a greater risk when earnings of the company fluctuate;
(ii) In case of redeemable debentures, the company has to make provisions for
repayment on the specified date, even during periods of financial difficulty;
iii. CRISIL (Credit Rating and Information Services of India Ltd.)
iv. On aspects like track record of the company, its profitability, debt servicing
capacity, credit worthiness and the perceived risk of lending.

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