Distinguish between internal and external sources of finance
Compare debt and equity financing and their implications
Explain the range of short and long-term financing options
Evaluate the factors influencing the choice of finance
Assess the role of venture capital and crowdfunding in modern finance
Internal Sources
Internal Finance
Key Advantage
Internal finance costs no interest and requires no repayment — it does not dilute ownership or increase financial risk. However, it is limited by the firm's own financial position.
Retained profit: Most important internal source — previous years' undistributed earnings; no cost; no dilution; but reduces dividends
Sale of assets: Selling unused property, vehicles, equipment — releases capital but asset is lost; only available if assets are held
Working capital management: Reducing stock, collecting debtors faster, extending creditor payment — improves liquidity without raising finance
Sale and leaseback: Sell an asset (e.g. premises) to a financial institution then lease it back — raises capital while retaining use; common in retail
External Finance: Debt
Debt Financing
Bank Loan
Fixed or variable interest; set repayment schedule
Good for assets that depreciate quickly (vehicles, technology)
Trade Credit
Pay suppliers 30–90 days after delivery
Free short-term finance; delays cash outflow
Stretching too far damages supplier relationships
Invoice Factoring
Sell unpaid invoices to a factor at a discount (e.g. 90p per £1)
Immediate cash; factor collects from customers
Costly; customers may react poorly to factor contact
External Finance: Equity
Equity Financing
Share Issue (Rights Issue / IPO)
IPO: Float on stock exchange — raises large capital; loss of private ownership; ongoing reporting obligations
Rights issue: Offer new shares to existing shareholders at discount
No interest; no repayment; dividends are discretionary
Dilutes ownership and EPS; vulnerable to hostile takeover
Venture Capital & Private Equity
Venture Capital: Investment in early-stage businesses with high growth potential; VC takes equity stake + board seat
Private Equity: Investment in established private companies; typically aims to buy, improve, then sell within 5–7 years
Brings expertise and networks alongside capital
Founder loses some control; VC expects high exit return (10×)
Crowdfunding: Equity crowdfunding (Seedrs, Crowdcube) allows businesses to raise from many small investors via a platform. Good for brand-building; complex to manage many shareholders; limited amounts typically raised.
Key Comparison
Debt vs Equity: Key Trade-offs
Advantages of Debt
No dilution of ownership or control
Interest is tax-deductible (reduces corporation tax)
Cheaper than equity (lower required return)
Predictable: fixed repayment schedule
Risks of Debt
Fixed interest must be paid regardless of profit
High gearing increases financial fragility
Covenants may restrict business decisions
Repayment required — cash flow pressure
Advantages of Equity
No compulsory repayment or interest
Reduces gearing; stronger balance sheet
VC/PE brings strategic expertise
Risks of Equity
Dilutes existing ownership (loss of control)
Dividends expected; market pressure on performance
IPO process is costly and complex
Decision Framework
Factors Influencing the Choice of Finance
Purpose and time horizon: Match the duration of the asset to the finance — use long-term debt for machinery, overdraft for seasonal cash flow
Current gearing level: Highly geared firms struggle to raise more debt — must turn to equity; low gearing gives headroom for debt
Business size and legal form: PLCs can issue shares; private companies and partnerships cannot access public equity markets
Interest rate environment: Low rates favour debt; high rates make equity relatively more attractive
Control considerations: Founders resistant to dilution prefer debt; growth-stage firms without assets may have no choice but equity
Practice Question 1
A private limited company with high gearing needs £500,000 to fund a new factory. Which source of finance is most appropriate?
AOverdraft — flexible and quick to arrange
BEquity share issue to venture capitalists — avoids adding more debt to an already highly geared balance sheet
CTrade credit — defer payment to suppliers
DDebentures — issue corporate bonds on the stock exchange
B is correct. High gearing means the firm already has substantial debt — adding more increases risk. Equity via venture capital avoids further debt while providing capital. Overdraft (A) is short-term and inappropriate for a long-term factory; trade credit (C) is far too small; debentures on the stock exchange (D) are unavailable to private limited companies.
Practice Question 2
A growing tech start-up has no assets to offer as security and needs £2m to develop its product. Which finance source best suits this situation?
ABank loan secured on property
BVenture capital — equity investment in exchange for stake
CRights issue to existing shareholders
DSale and leaseback of premises
B is correct. With no assets (no security for bank loan), no track record (risky for debt), and as a start-up (no existing shareholders for rights issue, no premises to sell-and-leaseback), venture capital is designed precisely for this scenario — high-risk early-stage businesses where equity is the only viable route. VC investors accept this risk in exchange for equity and high growth expectations.
Practice Question 3
A retailer sells its freehold store to a property company for £3m and immediately signs a 25-year lease to continue using it. This is:
AA bank loan secured on commercial property
BSale and leaseback — raises capital while retaining use of the asset
CA rights issue to shareholders funded by property disposal
DInvoice factoring using the store's future rental income
B is correct. Sale and leaseback involves selling an asset to a third party (releasing capital) while signing a lease to continue using it operationally. The retailer gets £3m cash but commits to annual lease payments. Common in retail — Tesco, Marks & Spencer and many others have used this to release capital tied up in property while maintaining operational continuity.
Practice Question 4
A firm's finance director argues that debt is cheaper than equity because interest is tax-deductible. Which statement best evaluates this view?
AThe view is entirely correct — debt is always cheaper and preferable to equity
BThe view is partially correct — debt has a tax advantage but increases financial risk through fixed obligations and higher gearing
CThe view is incorrect — equity is always cheaper because no interest is paid
DThe view is incorrect — interest payments are not deductible under UK tax rules
B is correct. Interest on debt is indeed tax-deductible, reducing the effective cost. However, debt is not unconditionally preferable — high gearing increases financial fragility, fixed interest obligations strain cash flow in downturns, and lenders may impose restrictive covenants. The optimal capital structure balances the tax benefit of debt against the increased risk.
Summary
Key Takeaways
Internal finance: Retained profit, asset disposal, sale-and-leaseback — no cost or dilution; limited by existing position
Debt: Bank loans, debentures, overdraft — no dilution; tax-deductible; adds gearing risk and fixed obligations
Equity: Share issue, VC, crowdfunding — no repayment; dilutes ownership; no financial obligation in downturns
Match purpose to source: Long-term assets → long-term finance; short-term cash gaps → overdraft/trade credit
Factors: Current gearing, business size, legal form, interest rates, control preferences — all shape the optimal choice