Briefly explain the term debt and equty

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ASSIGNMENT
OPERATION AND PRODUCTION MANAGEMENT
GeneralQuestion:
Q1.Define the term Debt and briefly explain main sources of short term debt and long term debt for
business organization with relative merits and demerits?
Term Debt:Has a remuneration which is independent of the company’s results and is contractually set in advance.
Except in some extreme cases (a missed payment, or bankruptcy), the lender will receive the interest due to him
regardless of whether the company’s results are excellent, average or poor.
a).Always has a repayment date, however far off, that is also set contractually. We will set aside, for the moment,
the rare case of perpetual debt;
b).Is paid off ahead of equity when the company is liquidated and its assets sold off. The proceeds will first be used
to pay off creditors, and only when they have been fully repaid will any surplus be paid to shareholders.
Define the Debt?
Debt is an amount of money borrowed by one party from another. Debt is used by many corporations and
individuals as a method of making large purchases that they could not afford under normal circumstances.
A debt arrangement gives the borrowing party permission to borrow money under the condition that it is
to be paid back at a later date, usually with interest.
What is Short-Term Debt?
Short term debt, also called current liabilities, is a firm's financial obligations that are expected to be paid
off within a year. It is listed under the current liabilities portion of the total liabilities section of a
company's balance sheet.
Main sources of short term debt
1.Overdraft Agreement:
By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to a
certain limit without the need for further discussion. The bank might ask for security in the form of
collateral and they might charge daily interest at a variable rate on the outstanding debt.
2.Accounts Receivable Financing:
Many banks and non-banking financial institutions provide invoice discounting facilities. The company
takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due date
the bank collects the money from the customer.
3.Customer Advances:
There are many companies that insist on the customer making an advance payment before selling them
goods or providing a service. This is especially true while dealing with large orders that take a long time
to fulfill.
4. Selling Goods on Installment:
Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles and so on,
allow customers to make their payments in installments.
5.Trade Credit.
Just as a firm grants credit to its customers it can also get credit from the manufacturers or wholesalers or
suppliers. It is known as trade or mercantile credit.
6. Accounts Receivable Financing
Under this method, a financing company purchases the account receivables from the customers or money
is advanced on the security of the accounts receivable. In short, it is a method of getting credit by
pledging book debts.
7.Commercial bank.
Commercial bank lending appears on the balance sheet as notes payable and is second in importance to
trade credit as a source of short-term financing.
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8.commercial paper.
Commercial paper, a third source of short-term credit, consists of well-established firms’ promissory
notes sold primarily to other businesses, insurance companies, pension funds, and banks. Commercial
paper is issued for periods varying from two to six months.
9. CREDIT FACTORING.
This financial service, first developed in the USA, involves purchase of an acknowledged debt by a credit
factor against a charge.
10. INVOICE DISCOUNTING
The service is similar to the credit factor's providing of fund against invoice. Companies give invoices to
financial houses for their
What Is Long-Term Debt?
Long-term debt is debt that matures in more than one year. Long-term debt can be viewed from two
perspectives: financial statement reporting by the issuer and financial investing. In financial statement
reporting, companies must record long-term debt issuance and all of its associated payment obligations on
its financial statements.
A debt is a promise to repay principal (the original amount of the loan) plus interest, at a speci…ed time
to the lender, or creditor. The corporation is the debtor or borrower, and the amount owed to the creditor
is a liability of the corporation.
Sources of long term Debt
1.Long-Term Loan from a Bank:
Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their
working capital needs for two, three or more years.
2.Retain Profits:
Rather than making dividend payments to shareholders or investing in new ventures, many businesses
retain a portion of their profits so that they may use it for working capital. This way they do not have to
take loans, pay interest, incur losses on discounted bills, and they can be self-sufficient in their financing.
3. Issue Equities and Debentures:
In extreme cases when the business is really short of funds, or when the company is investing in a large-
scale venture, they might decide to issue debentures or bonds to the general public or in some cases even
equity stock.
4.Selling of Assets.
As firms grow they build up assets. These assets could be in the form of property, machinery, equipment,
other companies or even logos. In some cases it may be appropriate for a business to sell off some of
these assets to finance other projects.
5. private equity funds
private equity funds and their ownership of a large portion of the world’s private sector businesses. A
private equity fund pools finance from various investors (very rich private individuals and the
institutions). The fund then uses the finance to buy private sector businesses, often ones that were stock
market listed.
6. Preference shares
Preference shares represent part of the risk-bearing ownership of the company, although they usually
confer on their holders a right to receive the first slice of any dividend that is paid.
7. Ordinary shares
Ordinary shares are issued by the company to investors who are prepared to expose themselves to risk in
order also to expose themselves to the expectation of high investment returns, which both intuition and
the evidence, which we shall come across later in the book, tell us is associated with risk.
8. Bonds
Bonds are long-term debt obligations (liabilities) of corporations and governments. A bond certificate is
issued as proof of the obligation. The issuer of a bond must pay the buyer a fixed amount of money—
called interest, stated as the coupon rate—on a regular schedule, typically every six months.

3. MUHAMMAD ADIL Reference BY ACCA F9 &CORPORATE FINANCE ROLL NO:(06)013013
9. mortgage loan
A mortgage loan is a long-term loan made against real estate as collateral. The lender takes a mortgage on
the property, which lets the lender seize the property, sell it, and use the proceeds to pay off the loan if the
borrower fails to make the scheduled payments. Long-term mortgage loans are often used to finance
office buildings, factories, and warehouses.
10. Debenture
A debenture is a document that either creates or acknowledges a debt, and the debt is one without
collateral. In corporate finance, debenture refers to a medium- to long-term debt instrument used by large
companies to borrow money. In some countries, the term is used interchangeably with bond, loan stock,
or note.
Merits and demerits of debt
Merits of Debt
a) Control: Taking out a loan is temporary. The relationship ends when the debt is repaid. The lender
does not have any say in how the owner runs his business.
b) Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are not.
c) Predictability: Principal and interest payments are stated in advance, so it is easier to work these into the
company's cash flow. Loans can be short, medium or long term.
d) Scope for Expansion: Debt financing allows business to expand its operations. New branches can be
opened in other cities and countries. New lines of business can be adopted to increase revenues. The easy
availability of credit encourages entrepreneur to take new risks and float new products.
e) Researchand Development: Debt financing allows the process of research and development. Loans
taken from banks can be used to accelerate R & D activities. Earning potential of the company increases
when the research hard products are floated in the market.
f) High Profit: Due to expansion of business and use of new techniques the revenues and profits of the
business also grow. Huge revenues means that there will be a room for further expansion of the business.
Higher profit can also be used to repay the bank loans. Thus increasing the solvency of business.
g) Tax Advantage: As the interest charge is subtracted from net income before applying tax rate, so this
leads to lower tax liability.
Demerits of Debt
a) Qualification: The company and the owner must have acceptable credit ratings to qualify.
b) Fixed payments: Principal and interest payments must be made on specified dates without fail.
Businesses that have unpredictable cash flows might have difficulties making loan payments. Declines in
sales can create serious problems in meeting loan payment dates.
c) Cash flow: Taking on too much debt makes the business more likely to have problems meeting loan
payments if cash flow declines. Investors will also see the company as a higher risk and be reluctant to
make additional equity investments.
d) Collateral: Lenders will typically demand that certain assets of the company be held as collateral, and the
owner is often required to guarantee the loan personally.
e) Interest Payments: Very huge amount out of net profit of the business have to be paid on account of
interest on borrowed capital.
f) Depression: If a business comes under depression and losses occur, then the payments of interest could
become a great problem due to inadequacy of funds.
g) Risky Investment: If a business is already running on the huge borrowed capital, further investment in a
business becomes risky. This risk discourages investors. Banks also hesitate to grant loans to such
business which are already under debt burden.
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Q2.Define the term Equity and briefly explain the main sources of equity finance for business with relative
merits and demerits?
What Is Equity
Equity is typically referred to as shareholder equity (also known as shareholders' equity) which represents
the amount of money that would be returned to a company’s shareholders if all of the assets were
liquidated and all of the company's debt was paid off.
Equity is a representation of ownership in an enterprise allocated to individuals or other entities in the
form of ownership units (or shares). Equity can be used as a financing tool by for-profit businesses in
exchange for ownership (control) and an expected return to investors.
Main sources of Equity
1.Business angels
Business angels (BAs) are wealthy individuals who invest in high growth businesses in return for a share
in the business. Some BAs invest on their own or as part of a network. BAs are often experienced
entrepreneurs and in addition to money, they bring their own skills, knowledge and contacts to the
company.
2. Venture capital
Venture capital is also known as private equity finance. Venture capitalists (VCs) look to invest larger
sums of money than BAs in return for equity.
3. Crowdfunding
Crowdfunding is where a number of people each invest, lend or contribute small amounts of money to
your business or idea. This money is combined to help you reach your funding goal.
4.Enterprise Investment Scheme (EIS)
Some limited companies can raise funds under the EIS. The scheme applies to small companies carrying
on a qualifying trade.
There are potential tax advantages for individuals who invest in such companies, such as:
a).the buyer of the shares gets income tax relief at 30 per cent on the cost of the shares
b).Capital Gains Tax (CGT) on the sale of other assets can be deferred if the gain is reinvested into EIS
shares
5.Alternative Platform Finance Scheme
If your small business is struggling to access bank finance, there is now a new government scheme in
which the UK's biggest banks will pass on details of any businesses they have rejected to three alternative
finance providers.
6.The stock market
Joining a public market or stock market is another route through which equity finance can be raised. A
stock market listing can help companies access capital for growth and raise finance for further
development.
7. RETAINED EARNINGS
A company can finance itself by retaining its earnings, instead of distributing it to the owners. This is a
part of owner’s equity. This way the company is not required to look for other sources of equity finance as
it has an inherent solution.
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Merits and Demerits of Equity finance
Merits of Equity finance
 Less risk: You have less risk with equity financing because you don't have any fixed monthly loan
payments to make. This can be particularly helpful with startup businesses that may not have positive
cash flows during the early months.
 Credit problems: If you have credit problems, equity financing may be the only choice for funds to
finance growth. Even if debt financing is offered, the interest rate may be too high and the payments
too steep to be acceptable.
 Cash flow: Equity financing does not take funds out of the business. Debt loan repayments take
funds out of the company's cash flow, reducing the money needed to finance growth.
 Long-term planning: Equity investors do not expect to receive an immediate return on their
investment. They have a long-term view and also face the possibility of losing their money if the
business fails.
 Motivation: As in equity finance all the profit remain with the owner, so it gives him motivation to
work more hard. The sense of inspiration and care is greater in a business which is financed by
owner’s own money. This keeps the businessman conscious and active to seek opportunities and earn
profit.
 No Interest: No interest is paid to any outsider in case of equity finance. This increases the net
income of the business which can be used to expand the scale of operations.
 Credit Worthiness: High equity finance increases credit worthiness. A business in which equity
finance has high proportion can easily take loan from banks. In contrast to those companies which are
under serious debt burden, no longer remain attractive for investors.
 Liquidation: In case of winding up or liquidation there is no outsiders charge on the assets of the
business. All the assets remain with the owner.
 Freedom from debt - unlike debt finance, you don't make repayments on investments. Not having
the burden of debt can be a huge advantage, particularly for small start-up businesses.
 Business experience and contacts - as well as funds, investors often bring valuable experience,
managerial or technical skills, contacts or networks, and credibility to the business.
 Follow-up funding - investors are often willing to provide additional funding as the business
develops and grows.
Demerits of Equity finance
 Cost: Equity investors expect to receive a return on their money. The business owner must be willing
to share some of the company's profit with his equity partners. The amount of money paid to the
partners could be higher than the interest rates on debt financing.
 Loss of Control: The owner has to give up some control of his company when he takes on additional
investors. Equity partners want to have a voice in making the decisions of the business, especially the
big decisions.
 Potential for Conflict: All the partners will not always agree when making decisions. These
conflicts can erupt from different visions for the company and disagreements on management styles.
An owner must be willing to deal with these differences of opinions.
 Decrease in Working Capital: If majority of funds of business are invested in fixed assets then
business may feel shortage of working capital. This problem is common in small scale businesses.
The owner has a fixed amount of capital to start with and major proportion of it is consumed by fixed
assets. So less is left to meet current expenses of the business.
 Difficulties in Making Regular Payments: In case of equity finance the businessman may feel
problems in making payments of regular and recurring nature. Sales revenues sometimes may fall due

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to seasonal factors. If sufficient funds are not available then there would be difficulties in meeting
short term liabilities.
 Higher Taxes: As no interest has to be paid to any outsider so taxable income of the business is
greater. This results in higher incidence of taxes. Further there is double taxation in certain cases. In
case of joint stock company the whole income is taxed prior to any appropriation.
 Limited Expansion: Due to equity finance the businessman is not able to increase the scale of
operations. Expansion of the business needs huge finance for establishing new plant and capturing
more markets. Small scales businesses also do not have any professional guidance available to them
to extend their market.
 Delay in Replacement: Businesses that run on equity finance, face problems at the time of
modernization or replacement of the capital equipments when it wears out. The owner tries to use the
current equipments as long as possible.
 Time and money - approaching investors and becoming investment-ready is demanding. It takes
time and money. Your business may suffer if you have to spend a lot of time on investment
strategies.
 Personal relationships - accepting investment funds from family or friends can affect personal
relationships if the business fails.
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