PROFESSIONAL PRACTICES

(HU 2×1)

LECTURE # 17

MUHAMMAD ASAD

INSTRUCTOR
DEPARTMENT OF COMPUTER SCIENCE
Key Learning Point :-

- Discussion about debt and equity financing strategies

 WHAT IS CAPITAL STRUCTURE?
 The amount of debt and/or equity employed by a organization --- To fund
its operations, and finance its assets. A organization’s capital structure is
typically expressed as a debt-to-equity or debt-to-capital ratio.

 Debt and equity capital are used to fund a organization’s operations,

capital expenditures, acquisitions, and other investments.

 There are adjustments organizations have to make --- When they decide
whether to use debt or equity to finance operations --- and --- Managers
will balance the debt and equity to find the optimal capital structure.
 CAPITAL STRUCTURE

DEBT
RS.500

ASSETS
Rs. 1000

EQUITY
RS.500
OPTIMAL CAPITAL STRUCTURE
 The optimal capital structure of an organization is often defined as the
proportion of debt and equity --- That results in the lowest weighted
average cost of capital (WACC) for the organization.

 This technical definition is not always used in practice --- and ---
Organizations often have a strategic or philosophical view of what the ideal
structure should be.

 In order to optimize the structure, an organization can issue either more

debt or equity --- The new capital that’s generated may be used to invest
in new assets --- or --- may be used to repurchase debt/equity that’s
currently outstanding, as a form of recapitalization.
LEVERAGE

 Leverage refers to the use of debt (borrowed funds) to increase returns

from an investment or project --- Companies use leverage / debt to raise
capital --- To finance their assets and invest in business operations.

 The interest expense and credit risk are associated with Debt finance.

 A company that financed its assets with more equity than debt has a low
leverage --- A company that financed its assets with more debt than equity
has a high leverage.
 CAPITAL STRUCTURE CAPITAL STRUCTURE
LOW LEVERAGE HIGH LEVERAGE

DEBT
RS.200
DEBT
ASSETS ASSETS RS.800
Rs. 1000 Rs. 1000

EQUITY
RS.800

EQUITY
RS.200
 NOTE
Leverage magnifies both gains and losses --- On one hand, debt financing
increased the shareholder profit (because profit divided among existing
shareholder) --- On the other hand, if the investment moves against the investor,
their loss is much greater (because loss divided among existing shareholder).

ABC Ltd. has three partners --- Wants to expand its business operation,
required Rs. 100,000.
In case of equity financing, add partner or partners share profit and also share
loss.
In case of debt financing, may be borrow from bank --- not shared profit and
loss as well --- magnifies both gains and losses.
 SOURCES OF FINANCING
DEBT & EQUITY
Sources of financing are classified internal or external
INTERNAL SOURCES
Finance from within the business

EXTERNAL SOURCES
Finance from outside the business
INTERNAL SOURCES OF EQUITY FINANCE
1: OWNERS FUND/CAPITAL
The owner of the business uses their own personal savings and
invests in the business.

ADVANTAGES
No money to pay back
No interest to pay
DISADVANTAGES
Lose savings
Limited amount
2: SALE OF ASSETS
The business decides to sell its asset and use that money to invest in the
business.

ADVANTAGES
Got finance for investment
No money to pay back
No interest to pay
DISADVANTAGES
The sold asset is lost
Not surplus asset
3: RETAINED EARNING AND PROFIT
The business decide to used the retained earning and profit they earned
at the end of a period for investment purpose. This profit reinvested into
business.

ADVANTAGES
No money to pay back
No interest to pay
DISADVANTAGES
No finance available for rainy days
EXTERNAL SOURCES OF EQUITY FINANCE
1: NEW PARTNER
Partners can bring finance or something other than money — new talents or
productive capability.

ADVANTAGES
Share loss
No money to pay back
No interest to pay
DISADVANTAGES
Dividend pay
2: GOVERNMENT GRANT (FINANCAIL ASSISTANCE)
 An award of financial assistance in the form of money by the federal government for
business or personal purposes with no expectation that the funds will be paid back.
 The grant offering typically includes conditions that must be met, such as reporting
performance or results and may be offer for research, business development, education
or other activities that are anticipated to support a common cause.
ADVANTAGES
No money to pay back
No interest to pay
DISADVANTAGES
Government agencies usually have very strict criteria.

you cannot use the money however you want.

3: SHARES
Shareholder are owners of a company. Ordinary shares & Preference shares.

ADVANTAGES
No interest to pay
Share loss
DISADVANTAGES
Dividend pay
INTERNAL SOURCES OF DEBT FINANCE
1: BONDS & DEBENTURE
 Governments (at all levels) and corporations commonly use bonds in order to borrow
money. Governments need to fund roads, schools, dams or other infrastructure. 
corporations will often borrow to grow their business, to buy property and equipment,
to undertake profitable projects, for research and development or to hire employees.
 Bonds represent debt obligations – the repayment of the borrow money at maturity
date + periodic interest to be paid to the bond holder.

ADVANTAGES
Raise funds for investment
DISADVANTAGES
Interest and principal repayment obligations
Collateral something
2: TRADE CREDIT
A trade credit is an agreement or understanding between agents engaged in
business with each other that allows the exchange of goods and services
without any immediate exchange of money. Such as Assets based lending
and suppliers.

ADVANTAGES
An essential tool for financing growth
Doesn't involve lengthy paperwork and waiting (like bank loan)
DISADVANTAGES
Higher cost (Discount on cash sale)
3: FACTORING
 Factoring is a financial service in which the business entity sells its bill
receivables to a third party at a discount in order to raise funds.
 Recourse factoring and Non-recourse factoring

ADVANTAGES
Doesn't involve lengthy paperwork and waiting (like bank loan)
Raised temporary funds fast
DISADVANTAGES
The cost of factoring is very high.
The company needs to show all details about company customers and sales to
factor
Bad behavior of factor with the debtors (Goodwill of the company)
EXTERNAL SOURCES OF DEBT FINANCE
1: FINANCIAL INSTITUTIONS
Borrowing an amount of money from banks, lending companies and
welfare institutions --- payback in installments.

ADVANTAGES
Enhance business
DISADVANTAGES
Pay Interest + Principle
Assets for collateral
2: OVERDRAFT
Business is allowed to be overdrawn on its bank account up to certain limit.

ADVANTAGES
Cheaper than a bank loan
DISADVANTAGES
Interest is charged for daily basis (High as compare to loan)
3: HIRING & LEASING
Allows business or individuals to possess and control an asset during an
agreed term, while paying rent or instalments.

ADVANTAGES
No need funds for buying an asset
DISADVANTAGES
Can’t be sale
Expensive (Interest + Capital cost)
4: GOVERNMENT GRANT (LOW INTEREST RATE)
 An financial assistance in the form of money by the federal government for business or
personal purposes. The funds will be paid back according to predefined schedule at low
rates either installments or lump sum.

 The grant offering typically includes conditions that must be met, such as reporting
performance or results and may be offer for research, business development, education or
other activities that are anticipated to support a common cause.
ADVANTAGES
Easy pay back schedule
Low interest to pay
DISADVANTAGES:
Government agencies usually have very strict criteria.
May be you cannot use the money however you want.
5: FRIENDS AND FAMILY

ADVANTAGES
May lend funds interest-free or at a low rate.
May agree to a longer repayment period

DISADVANTAGES

you could lose more than money—you could lose a valuable relationship
 SOURCES OF FINANCING EQUITY & DEBT
INTERNAL SOURCES OF EQUITY FINANCE INTERNAL SOURCES OF DEBT FINANCE

OWNERS FUND/CAPITAL BONDS & DEBENTURE

SALE OF ASSETS TRADE CREDIT

RETAINED EARNING AND PROFIT FACTORING

EXTERNAL SOURCES OF EQUITY EXTERNAL SOURCES OF DEBT FINANCE

FINANCE
FINANCIAL INSTITUTIONS
NEW PARTNER
OVERDRAFT
GOVERNMENT GRANT
HIRING & LEASING
SHARES
FRIENDS AND FAMILY
 ANY QUESTION

You can contact me at: asadali@uosahiwal.edu.pk

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