Lecture 03 : Sources of Finance for a Firm

Summary

The video discusses the challenges startups in India face, particularly around securing and managing funding, which often leads to their failure. It explores the financing cycle, detailing the flow of money in the economy, from production to consumption, and the crucial role financial institutions play in supporting businesses. The video also covers various sources of funding, including retained earnings, short-term and long-term borrowing, equity, and venture capital, explaining their costs, risks, and impact on businesses. The overall focus is on how companies can effectively manage their finances to ensure long-term success.

Takeaways

• 💡 Over half of startups in India fail due to a lack of adequate funding or inability to manage the cost associated with the funds secured.
• 💸 Financial institutions play a vital role in connecting money with ideas, ensuring a smooth flow of funds in the economy.
• 📈 The financing cycle involves money flowing from governments, institutions, and individuals to businesses, which in turn invest in production, pay wages, and generate profits, which flow back to individuals and investors.
• 🏦 Banks source money through deposits and offer loans at higher interest rates, making profits in the process.
• 📊 Insurance companies charge premiums for risk coverage and invest these funds in financial instruments to pay for claims.
• 💰 Mutual funds pool small investments from individuals, investing them in financial markets on behalf of investors, generating returns in the form of dividends.
• 👨‍👩‍👦 Pension funds manage retirement savings, investing in low-risk financial instruments to ensure steady returns after retirement.
• 🚀 Venture capital (VC) firms invest in high-risk startups, while private equity (PE) funds typically buy entire companies using a mix of equity and debt.
• 📉 Retained earnings are a firm's first source of funding for future growth, followed by short-term borrowings, long-term borrowings (bonds/debentures), and finally, equity if necessary.
• ⚖️ Financial decisions within firms are based on balancing cost, risk, and control, with retained earnings being the least risky and equity financing being the most costly and dilutive in terms of ownership.

Q & A

What is one of the main reasons startups in India fail?

More than half of the startups in India fail because they are unable to secure adequate funding or manage the costs and expectations associated with the funds they do secure.

What is the 'financing cycle' in corporate finance?

The financing cycle refers to the movement of money from financial institutions to businesses and individuals, which is then used for production, wages, and interest payments. This money eventually returns to individuals as wages or profits, who then save and invest it back into the financial system.

How do banks typically operate in the financial system?

Banks collect money from individuals and institutions in the form of deposits at a lower cost, and then offer this money as loans to businesses and people at a higher cost, generating profit in the process.

What role do insurance companies play in the financial system?

Insurance companies offer security against uncertain future events by charging premiums. They invest these premiums in financial instruments like bonds and stocks, generating returns to pay claims when necessary.

How do mutual funds help small investors?

Mutual funds accumulate small savings from individuals and invest them in financial markets, such as the stock or bond markets, on behalf of investors. They provide professional money management services and pay returns in the form of dividends.

What is the difference between venture capital (VC) and private equity (PE) funds?

Venture capital funds typically invest in high-risk startups with the potential for high returns, while private equity funds usually invest in established companies by acquiring them through a mix of equity and debt.

What is the first source of funds for a business when it needs financing?

The first source of funds for a business is typically retained earnings, which are profits that are kept within the business to fund future growth.

When would a business choose to issue equity as a source of funds?

A business would choose to issue equity as a source of funds when other sources, like retained earnings and borrowing, are insufficient. Equity financing is generally more expensive and risky, as it dilutes the ownership and control of the company.

What is the role of financial institutions in the financial system?

Financial institutions channel money from savers to businesses and individuals in need of funds. They also create additional value by generating returns on the money invested or lent, which they pass back to the savers and investors.

What are the implications of the 'priority structure' in financing?

The priority structure in financing determines the order in which different security holders are paid from a firm's income. Debt holders are paid first, followed by subordinate debt holders, preferred stockholders, and lastly, common stockholders, who are considered residual claim holders.

Outlines

00:00

💡 Introduction to Funding Challenges for Startups

This paragraph introduces the issue of startup failures due to inadequate funding in India. Even when funding is secured, startups may struggle to manage costs and meet expectations. The paragraph sets the stage for a broader discussion on corporate finance and how firms, both startups and established companies, should manage various funding sources to ensure smooth operations.

05:00

🏦 Overview of Financial Institutions and Their Roles

This paragraph discusses the financing cycle and the critical role of financial institutions in facilitating money flow. It explains how companies secure funds from different sources, such as banks or the government, to pay for production costs like wages and interest. The money circulates through individuals’ consumption, savings, and investments back into the economy, creating a financial loop that supports businesses and individuals alike.

10:03

🏢 Types of Financial Institutions

The paragraph explores various types of financial institutions and their distinct roles. Banks collect deposits and offer loans at a higher interest rate to earn profits, while insurance companies provide security through premium-based products. It also introduces mutual funds, which pool small savings for investment, and pension funds, which focus on retirement savings by investing in low-risk financial securities.

15:03

💼 Venture Capital and Private Equity

This section focuses on venture capital and private equity funds. It highlights how venture capital firms invest in high-risk, high-reward startups using money from wealthy individuals and endowments. Private equity firms, on the other hand, buy entire companies by leveraging debt and equity, creating profit through their investments in larger, more established companies.

20:04

🔄 Sources of Funds for Businesses

This paragraph delves into the different sources of funding for businesses. The first source is retained earnings, where companies use their profits to reinvest in the business. If more funds are needed, businesses might seek short-term borrowings, loans, or issue equity. The importance of using each source of funding is illustrated through a relatable example of purchasing everyday items, emphasizing the hierarchy and accessibility of funds.

25:07

📊 Funding Priority and Risk Levels

The paragraph explains how businesses prioritize their funding sources based on cost, risk, and flexibility. Retained earnings offer low-risk, low-cost funds but are limited in availability. Short-term borrowings provide moderate flexibility but also come with some risk. Equity financing, though riskier and more expensive, allows businesses to raise large sums when needed. The discussion covers the trade-offs involved in accessing various types of funding.

📈 Claim Priority Structure in Firms

Here, the claim priority structure within firms is analyzed. Debt holders have the first claim on a company's income, while equity holders only claim residuals. The paragraph breaks down how different levels of debt—such as secure debt and subordinate debt—affect the order in which investors are paid. This prioritization impacts how returns are distributed across the firm's financial structure.

🔑 Conclusion: The Role of Financial Institutions

In conclusion, this paragraph reinforces the vital role of financial institutions in the economy. These institutions not only channel money but also create additional value through lending and investments, generating returns for investors. The paragraph underscores the importance of a firm’s financing structure, which is determined by management decisions on risk, control, and cost.

Keywords

💡Financing Cycle

The financing cycle refers to the movement of money from various sources through financial institutions to businesses and individuals. In the video, it's explained how money moves from the government to businesses and individuals, which is then used for production, wages, and payments. Financial institutions play a key role in connecting funds with ideas and investments, ensuring a smooth flow of the financial system.

💡Financial Institutions

Financial institutions are entities like banks, insurance companies, mutual funds, and pension funds that channelize money in an economy. The video emphasizes their role in securing funds for businesses and individuals, offering different forms of financing like loans, insurance, and investment services. They help connect savers with borrowers, thus maintaining the financial system’s efficiency.

💡Sources of Funds

These are the various methods a company can use to obtain money for operations and growth, including retained earnings, short-term borrowings, long-term debt, and equity. The video explains how companies prioritize these sources depending on cost, risk, flexibility, and availability. Retained earnings are considered the cheapest and least risky, while equity is the most expensive and risky.

💡Retained Earnings

Retained earnings are the portion of a company's profit that is kept for reinvestment instead of being distributed to shareholders. In the video, it is presented as the primary source of funding for a business, offering low cost and risk but limited availability. Retained earnings provide flexibility since they are immediately accessible for business activities.

💡Short-term Borrowings

Short-term borrowings are funds borrowed for a short period, typically less than a year, often used to cover immediate financial needs. In the video, they are described as a moderate-cost and flexible source of funds, although their availability is generally limited compared to long-term financing. Companies might use this option when retained earnings are insufficient.

💡Long-term Borrowings

Long-term borrowings involve raising funds through instruments like bonds or loans that have a longer repayment period. The video mentions this as a riskier, costlier option with less flexibility due to the procedures involved in securing these funds. However, long-term borrowings can provide a significant amount of money for larger projects or investments.

💡Equity Financing

Equity financing is the process of raising capital by issuing shares in the company. It is portrayed in the video as the most expensive and risky source of funds because it dilutes ownership and control. Equity offers less flexibility and higher cost but can provide substantial funds if other sources are insufficient.

💡Debt Holders

Debt holders are individuals or institutions that have lent money to a company and hold a claim on the company’s income in the form of interest payments. The video describes them as having priority over equity holders in being paid off. They assume less risk compared to equity holders since they are repaid before any dividends are distributed to shareholders.

💡Mutual Funds

Mutual funds are financial institutions that pool money from many investors to invest in various financial instruments like stocks and bonds. In the video, they are highlighted as a way for individuals to invest smaller savings collectively, managed by professional money managers. This allows small investors to access larger financial markets and potentially gain higher returns.

💡Venture Capital Funds

Venture capital funds are investment funds that provide financing to startups and small businesses with high growth potential in exchange for equity. The video explains their role in the economy, where they accumulate money from wealthy individuals and endowments to invest in high-risk, high-return startups. They help foster innovation and business growth by providing funds where traditional financing might be unavailable.

Highlights

More than half of startups in India fail due to inadequate funding or failure to manage costs and returns.

The session will explain the financing cycle and the role of financial institutions in providing adequate funding for smooth business operations.

Financing cycle: Money moves through the economy from the government to businesses and individuals, which is used for production and returns as wages, profits, and interest.

Financial institutions like banks, insurance companies, mutual funds, and pension funds play key roles in managing and channeling funds for growth and development.

Banks source money from deposits at a lower cost and lend it at a higher rate, making a profit through loans.

Insurance companies use premiums to invest in financial instruments like bonds and stocks, paying claims with the returns generated.

Mutual funds pool small savings from individuals to invest in financial instruments, offering returns through dividends.

Pension funds invest retirement savings in low-risk financial securities to ensure steady returns after retirement.

Venture capital funds invest in startups with high risk but potentially high returns, backed by wealthy individuals or businesses.

Private equity funds invest in companies, often using a mix of equity and debt to buy firms outright.

Companies prioritize their funding sources, starting with retained earnings, then short-term borrowings, followed by long-term debt and finally equity financing.

Retained earnings are the lowest cost and risk source of funds but are limited in availability.

Equity financing, while offering large funds, comes at a high cost and risk, diluting ownership and control.

Financial institutions not only channel funds but also create additional value, offering savers and investors returns greater than their initial investments.

Equity holders have residual claims on profits, receiving returns only after debt holders and preferred stockholders have been paid.

Transcripts

[Music]

hello everyone

do you know that more than half

of the startups in india fail because

they are unable to secure adequate

funding

for their operations many a times

even if they are able to secure

sufficient fundings from different

sources

they are not able to honor the

cost associated with those fundings or

the expectations

in terms of returns and that is why they

fail to manage

the funds that they have secured in the

process

i welcome you back to the discussion

that we are we are having

in our course corporate finance

and in this session we will discuss

how a firm be it or established

company or a startup

should manage different sources of fund

in such a way that the business

runs smoothly with the help of funds

source

secured from different sources

in this session we will

start our discussion with explaining the

financing cycle

which will explain or which will help us

understand

the role of financial institutions in

brief

and then we will discuss how different

sources of

finance help a firm to maintain

the adequate flow of funds for their

operations

when we talk about the financing cycle

the cycle of movement of money

from one point to another we know

that the government provide money to

different

stakeholders in the society in business

in government and in corporations

that that money is typically used

for production that will that might

require purchases of

raw material payment of wages payment of

interest if the company has taken any

loan

so basically companies have the funds

the corporations which are engaged in

the production of

goods and services they have the funds

secured from different sources and that

fund can be used to buy material

pay labor charges or wages

pay interest payment on different

liabilities

and profits eventually these wages

profits and interest payments boiled

move further to the hands of individuals

who can use that money that inflow of

money

for their consumptions and in the

process of consumption

they spend money on buying the goods and

services that are produced by the

corporations or the companies in the

economy

after the consumption the individuals

save their money a part of their money

that they have received in terms of

wages profits or interest

and they further invested in

the market or in the economy through

financial institutions

so this financial cycle essentially

tells us

that people invest and save their money

that money passing through the loan

loans or stock

or any other financial instrument flows

back to the corporations

corporations use it to fund the growth

or the business activities by way of

producing the existing products and

services

or developing new products for

production

and sell those products and services

thereby generating profits and paying

wages

the money then flow back to the share

savers and the investors in the form of

wages

profit and interest payment in the

entire financial cycle we understand

that all financial institutions play a

vital role

at some point of time in the cycle by

way of connecting money

with ideas and returning the profit back

to the savers

and investors so to have a smooth

financial system

in an economy it is important to have

robust and efficient financial

institutions

now to quote some examples the type of

financial institutions that we have act

differently in the financial market or

in financial system in an economy

for example if you talk about banks

banks typically source the money

in form of deposits or the savings from

individuals or

institutions and that money is

used to offer to different

users of the money or different

institutions and individuals who require

money in the form of loan

so banks typically source money at a

lower cost

from individuals and institutions in the

form of deposits

and they use that money to

offer as loans to businesses and people

at higher cost and in the process they

make some profit

which are basically their return

for their efforts second type of

financial institutions that are

very much prevalent in the economy are

the insurance companies so we see the

insurance companies

typically offer insurance products or

services

which essentially provide us security

from some unwarranted on uncertain

situations in future

in charge in return of the premiums

and the investment earnings so insurance

companies

charge premium for their products or

services

and they use that premium for investing

in

different financial instruments

such as bonds sometimes stocks

and they use this return that they

generate from these

investment in financial instruments to

pay the

claims by the people who have taken the

insurance products and services

so basically these are second type of

institutions

another in financial institution that

play a vital role in channelizing money

from one point to another point in the

financial system

are mutual funds mutual funds typically

have

accumulated small savings from people

so people like you and me have

smaller amount of investment and we want

to invest it

ah this money with the help of

professional

money management services and mutual

funds

you come handy in that situation

where they use this smaller savings to

accumulate

into a bigger chunk of money and then

they invest this

money in stock market bonds and other

financial instruments

on behalf of the individual and small

investors

so basically they channelize this

small amount of savings from people to

invest that in financial instruments or

financial securities

in financial markets such as stock

market or bond market

and from the proceeds they pay back

to us in the form of dividends

another another type of funds are

pension funds

pension firms are basically dedicated ah

funds which have the retirement savings

contributed by people who are working

for their

post working phase of life so

basically when ah someone is employed in

ah

in a job or they are doing some

activities in a business

they would like to save some money in

order to have

a continuous flow of cash after their

work life

so they invest such money in retirement

funds

retirement funds in return they

invest those money in different

financial securities

financial instruments such as bonds

stocks or any other financial securities

with lower risk because they have to

keep the money safe

in order to pay back to the people after

their retirement

so the ultimate objective of pencil fund

is very similar to mutual fund

but they intend to pay the income

after retirement

another classification of financial

institutions

is venture capital fund and private

equity fund

in recent years we have heard a lot of

buzz around venture capital funds also

known as vc

and privacy private equity funds known

as

p e firms where they have source of

money in the form of investment by

wealthy individuals

such as high net worth individuals hnis

and endowments by the business houses or

rich families they use this money

to invest in startups for example

venture capital firms

invest their money that they have

accumulated from

wealthy people and endowments by

investing in startups where the risk is

high

but the possibility of earning

substantially higher return

is really high and thereby they make lot

of profit

in the process private equity funds

typically have a similar structure of

source of funds

but they invest in companies

which they can buy

in entirety using a small amount of

equity

and the remaining amount in the form of

debt

so if in in a very crude form a private

equity firm

would invest a smaller amount of their

own money in the form of equity

but they raise lot of money in terms of

borrowings in terms of

loan and then use that money to buy

companies as a whole

so these are some examples of financial

institutions and how they help

in generalizing the flow of money in the

financial system

now that we understand the role of

financial institutions

let us try to connect this with the

role of financial institutions for

providing the source of fund

for businesses since we know that

corporate finance decisions involved

ah sourcing of funds for business

activities

for operations ah for in

in a business that is why we need to

understand

how ah different sources of funds

provide different opportunities to a

business

so when we talk about sources of fund

for a firm

let us try to understand this with the

help of a simple example

suppose i have to buy something

i i am in a market and i need to buy

something

so if i have to buy something the first

avenue that i would look for

in terms of source of money will be my

own pocket

or wallet whatever is applicable so if i

need certain amount of money to buy

an item in the market i would reach out

to my wallet

to check if i have that much money that

is my first source of

fund if i do not have sufficient money

in my

pocket or wallet in order to buy that

item then the second alternative that i

might look

up to will be borrowing for from a

friend who is walking along with me in

the market

so that is my immediate source that is

short term borrowing from a friend

if i have to buy something really big

item such as lets say a home appliance

for example or

an ac or a refrigerator then probably i

need

a larger amount of money in that case

probably i need to take a loan from some

financing institutions such as bank or

any other credit institution

so that will be a long term loan because

the benefit of that item will be

for more than one year so the cost of

that item should also be spread over

multiple years so that is the second

third source of funds for me if that is

also not sufficient

then only i will dilute the ownership or

the shareholding

of the entity that is trying to acquire

something

with that source of money

contextualizing this

example in the form of a firm

if we look at different sources of funds

for a business

the first source of of

funds for a business should be retained

earnings

retained earnings are that part of

profits

generated by a firm which are kept

within the business

in order to fund further growth so

suppose

in a year if a business has earned 100

rupees of profit

it might not wish to distribute the

entire profit

back to the shareholders in the form of

dividend rather

it would like to keep a part of profit

in the form of retained earnings

that can be used in future so the first

source of fund for a business

is retained earnings if that is not

sufficient

then the short-term borrowings could be

the second source of funds

and if that is also not sufficient then

company might

try to borrow money for long term

which is basically by issuing bonds or

debentures

where the company would raise long term

debt

and if the company is not able to meet

the requirement of funds by way of

issuing debts or debenture

then only companies should issue equity

the priority or the choice of accessing

these sources of funds

would basically depend on different

characteristics

for example the retained earnings

is considered to be the lowest cost and

risk source of risky source of fund

which means if a company has to ah

consider

risk and cost as the decision criteria

retained earnings would be the lowest

costly

and lowest risky source of funds whereas

the equity source of fund by way of

issuing

equity shares would be considered the

highest

costly and highest risky if you look at

other characteristic of different

sources of funds

for example retained earnings is

considered to be a low risk

low cost source of fund and it offers

higher flexibility because it is

immediately available with the business

you have your own wallet with you so you

can easily access

funds as and when required so it offers

higher flexibility

but it has limited availability which

means

you cannot buy lot of things from the

money that you have in your pocket

right which means a company cannot use

retained earnings for investing in mega

projects

because the retained earnings might not

be sufficient

so it is limited in availability

when we look at the second source short

term borrowing

it again offers ah at low risk

but with moderate cost it has

moderate flexibility because you can

immediately ah

get access to short-term borrowings

from your banking partner or even

sometimes

from your suppliers but it also has

limited availability in terms of lower

amount of fund that are available for

uses whereas long term borrowing

such as debt of instrument bonds

and debentures they are considered

highly risky

and they are cost us moderate to high

they are also less flexible in terms of

uses

because you cannot immediately issue

bonds or debentures

in order to raise funds you need to

follow certain procedure it takes some

time

to issue bonds and shares or even if you

want to borrow lot large sum of money

from your bank

it might require certain ah established

procedure to be followed

in order to access those funds but

the amount of funds that might be

available will be high

and at the end the company might

consider

accessing equity financing as a source

of fund

but it offers funds at a higher risk

very high cost because typically equity

financing is considered to be

a source of fund that dilutes the

control and ownership of the business

and that is why it is considered to be

highly risky and highly

highly costly it is offered at

with less flexibility but it is

if it is approved by the board of

directors or any other stakeholders who

are associated with the process

there is no limitation on availability

which means the company can raise

substantial amount of money by way of

issuing equity shares

in the form of equity financing so we

know that for

each type of source of finance

for a firm the role of financial

associations

does ah is important and vital

in the form of offering different ah

funds at different maturity and

different cost

along with the risk

if we look at different sources of

finance and their claims on the profit

of the firm

we see that one of the goals of the

entire discussion on corporate finance

theory

is to predict our advice on security

issues

and pay out policies for the firm

in various stages of its life cycle

so when a company raises funds from

different sources

what is the requirement what is the cost

that the company is going to pay

and what is the risk that it is going to

assume by way of accessing that source

of fund

will be determining the

role of the process of securing funds

much discretion in this context will be

on the part of the management team of

the firm

that is involved in specifying different

features or different characteristics of

the

security through which the fund is

raised for example if it is raised

through

bond or debenture versus it is raised

through equity shares

the claims in terms of security cash

flow rights

control rights and other rights such as

collateral and options

should be considered and the discretion

of the management play an important part

these rights are also triggered and

exercised under

different contingencies for example if

the company has issued certain stock

options

and by which is it it is hoping to raise

certain amount of money

the exercise might be the the

exercise of buying that stock option or

exercising that stock option

by the holder of the stock options will

be

an important point where the fund will

fundraising will be affected

so if we look at the priority structure

if we consider that

different sources of funds have

different implications

in terms of the income of the fund funds

and the

ah the owner of the security holder

let us take an example of three

different type of security holders in a

firm so suppose that there are

two different type of holders of

financial securities

one is debt holders and another is

equity holders

we know that equity holders claim or

equity holders return

on the firm's income are will be

considered as the residual claim

because equity holders receive claim

on the firm income in this graph if you

see if r is considered to be the firm

income

d is the point after which equity

holders can claim

on the profit of the firm which is the r

of the in income of the firm

before that it is the debt holders

who have their claims

if the company has issued certain

subordinate date debt

which means it has issued an additional

debt that is on

over and above the debt level of d

so ah if we look at the third graph that

has

ah d ah that is extent of

amount of money raised from debt on the

top of that

there is ah d a lower case d which offer

which is basically the additional debt

that is raised by the firm

in that case the shareholders claim

on the return or the income of the

firm would be after the point

to which d and ah the the upper case d

and the lower case d are both combined

and paid to the

debt holders in the form of debt holders

claim or debt holders return

and subordinate debt holders return

so essentially the

claim priority structure is as following

the first priority is given to the

secure debt

so when the firm has certain income r

the first priority will be given to ah

the secured debt holders which means the

first payment will be made to

secure debt holders after that it will

be the ordinary debt holders who will be

given

their claims on the firm's income are

subsequent to which subordinate debt

holders will be paid

off from the income r of the firm

after which preferred stockholders will

be paid back

and then at the end the common

stockholders will be

paid off their claims and that is why

common stockholders are considered to be

having the residual claims on the firm's

income and this is why the

a choice of sources of funds is

are arranged in such a way that firms

typically

offer ah different rates of return

in terms of the income interest or the

rate of return for security holders

because of their priority on forms of

priority on firms income

and the associated risk

so in this session we briefly discussed

on the role of financial institutions

in an in a financial system where they

channelize

money from one point to another point

in order to make use of the money to the

most efficient point of possible ways

here financial institutions not only

channelize the money

but all in the process they also create

additional value

for example if ah a saver or an investor

has put

certain amount of money in financial

institution

the financial institution not only keeps

that money for further uses by way of

lending that money to financial

institutions

or other corporations but

also in the process they generate

additional value

and thereby giving return back to the

savers or the investors more than what

they had initially invested

we can relate this to an example that if

we invest hundred rupees

in ah an investment of venue or a

financial security

or for example let us say put as bank

deposit

after a period after certain amount of

time

we expect to get more than what we had

invested

so we are expecting to get more than 100

rupees and there

that is possible because financial

institution not only

channelize the money but also create

value

corporations or businesses obtain

finances from different sources

and the choice is made based on several

constraint including the cost constraint

control and risk factors equity holders

are the last recipient of the firm's

income

and ah there therefore they are known as

the residual claim holders debt holders

have the first claim on the firm's

income

and they get priority in terms of being

paid off

and for this it is

important to note that the financing

structure of a firm

is determined by the firm's priorities

or the management decision with respect

to the firm's priorities

in terms of cash flow rights control

rights

collateral and option as well as the

risk associated with different financial

structure

this is it for now thank you very much