question_answer

Describe briefly the factors responsible for selecting a source of finance.

Answer:

Ans.     Following factors responsible for selecting a source of finance:

(a) Cost: There are two types of cost viz., the cost of procurement of funds and cost of utilizing the funds. Both these costs should be taken into account while deciding about the source of funds that will be used by an organisation.

(b) Form of organisation and legal status: The form of business organisation and status influences the choice of a source for raising money. A partnership firm cannot raise money by issue of equity shares as these can be issued only by a joint stock company.

(c) Risk Profile: Business should evaluate each of the sources in terms of risk. For example, equity shares are to be repaid only at the time of liquidation of the company. While debentures need to be repaid on maturity date along with interest every six months or annually. Moreover, dividends are to be paid only if there are profits while interest is to be paid in case of loss as well.

(d) Financial Strength and Operational Stability: When the earnings of an organization are not stable, fixed charged funds like preference shares and debentures should be carefully chosen as they add to the fixed financial commitments of an organization.

(e) Purpose and Time Period: Business should select a source of finance according to time period for which funds are required. If funds are needed for short term, then we can make use of trade credit, commercial papers, bank loan, 'public deposits, etc but if funds are needed for long run then debentures, preference shares etc. are better.

(f) Control: A particular source of fund may affect the control and power of the owners of management of a firm. For example, equity shares dilute the control as they have voting power while other sources do not have voting power but loans from financial institutions, loans from commercial banks and issue of debentures get mortgaged on assets of the company. It dilutes power in different ways.

(g) Effect on Credit Worthiness: While choosing a source of finance, an organization also needs to consider its effect on credit worthiness. For example, if the company issues secured debentures then it affects the credit worthiness of company for unsecured debentures of the company. Their willingness to extend further loans as credit to the company gets adversely affected.

(h) Tax Benefits: Various sources of finance may also be evaluated in terms of their tax benefits. For example, interest on debentures is tax deductible while divided on preference shares is not tax deductible. Therefore those organizations which are seeking tax advantage may prefer debentures to preference shares.

(i) Flexibility and Ease: Another factor which determines the choice of a source of finance is how easily it is available i.e. how less the paper formalities are and how flexible it is i.e. how easily its amount and terms can be modified. '