Understand the key factors that influence a business’s choice of finance: cost, flexibility, control, intended use, and existing debt level. Use these factors to analyse and justify finance decisions in exam scenarios.
• Interest rates – Lower rates mean cheaper borrowing.
• Fees and charges – Origination fees, arrangement fees, and early‑repayment penalties add to cost.
• Tax implications – Interest on debt is usually tax‑deductible, reducing effective cost.
Analogy: Choosing a loan is like picking a car: a cheaper car (lower interest) saves money over time, but hidden maintenance costs (fees) can add up.
Exam Tip: When asked to compare two finance options, calculate the effective annual cost by adding interest and fees, then compare the after‑tax cost if interest is deductible.
• Fixed vs. variable payments – Fixed payments provide certainty; variable may adjust with cash flow.
• Early repayment options – Some lenders allow early payoff without penalty.
• Loan covenants – Restrictions on further borrowing or dividend payments.
Analogy: Flexibility is like a gym membership: a pay‑as‑you‑go plan (variable) lets you use it when you need, while a fixed plan guarantees access but locks you in.
Exam Tip: Identify which finance type (e.g., equity vs. debt) offers the most suitable repayment flexibility for the company’s projected cash flow.
• Equity finance – Dilutes ownership but no repayment obligation.
• Debt finance – Retains control but requires fixed repayments.
• Hybrid instruments – Convertible bonds give a mix of both.
Analogy: Taking equity is like inviting a partner to share the house; you get help but share the rent (profits). Taking debt is like renting a house: you keep it, but you must pay the landlord every month.
Exam Tip: When the company wants to keep decision‑making power, lean towards debt unless the cost of equity is extremely low.
• Capital expenditure (CAPEX) – Long‑term assets; often financed by debt due to tax shield.
• Working capital – Short‑term needs; usually financed by short‑term loans or overdrafts.
• Strategic projects – May require equity to signal confidence.
Analogy: Buying a new factory (CAPEX) is like buying a house: you want a long‑term loan. Buying inventory (working capital) is like buying groceries: you might use a credit card (short‑term).
Exam Tip: Match the finance type to the project’s duration and risk profile; justify why a particular source is optimal.
• Debt capacity – High existing debt limits new borrowing.
• Leverage ratios – Debt/EBITDA, interest coverage; regulators may set limits.
• Credit rating – Higher debt can lower rating, raising future costs.
Analogy: A student with many overdue library books (high debt) finds it harder to borrow new books (new finance).
Exam Tip: Calculate the company’s debt‑to‑equity ratio and discuss whether it can comfortably take on additional debt before recommending a finance option.
| Factor | Key Considerations | Typical Finance Choice |
|---|---|---|
| Cost | Interest rates, fees, tax deductibility | Debt (low cost), equity (high cost) |
| Flexibility | Repayment terms, covenants, early repayment | Short‑term loans, overdrafts |
| Control | Ownership dilution, voting rights | Equity (high control loss), debt (no control loss) |
| Use of Funds | CAPEX vs. working capital | Long‑term debt for CAPEX, short‑term credit for working capital |
| Existing Debt | Debt capacity, leverage ratios | Equity if debt capacity low, debt if capacity high |
A small manufacturing firm has a debt‑to‑equity ratio of 0.8 and is planning to invest £500,000 in new machinery. The firm can choose between a 5‑year bank loan at 6% interest or issuing new shares at a price that would dilute ownership by 10%.
Analyse which finance source is more appropriate, considering cost, flexibility, control, intended use, and existing debt.
Answer Guidance: