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Accounting 2e 2006 Michael Jones. Chapter 22 ... Accounting 2e 2006 Michael Jones. Cost of Capital I. Cost at which a business raises funds ...

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Chapter 22

The Management of Working Capital and Sources of Finance

The Management of Working Capital and Sources of Finance


2.Nature of Sources of Finance

3.Short-term Financing

  • Internal financing

  • External financing

  • Long-term Financing

    • Internal financing

    • External financing

      5.Cost of Capital

      6. Conclusion

  • Introduction

    • Sources of finance vital

    • May be internal or external

    • Businesses aim to optimise the use of their funds

    • Try to minimise short-term borrowings and finance long-term infrastructure as cheaply as possible

    Nature of Sources of Finance

    • Sources of finance: internal or external, short-term or long-term

    • If short-term should use for operational activities

    • If long-term should fund longer term infrastructure assets

    Short-Term Financing I

    • Management of working capital

    • Reduce amount of short-term finance used for day-to-day operations

    Short-Term Financing IIInternal Financing

    a. Cash

    b. Debtors

    i. Debtors collection model

    Seeks to maintain the optimal level of debtors by

    balancing extra revenue from increased sales

    with increased costs (e.g., credit control, bad


    Short-Term Financing IIIInternal Financing

    • Debtors Collection Model

    Short-Term Financing IV

    Short-Term Financing VInternal Financing

    c. Stock

    • Often extremely important asset

    • A buffer against excess demand

    • Stock control against theft and deterioration

      ii.Economic Order Quantity

      Determines optimal order quantity which minimises the costs of ordering and holding stock

    Short-Term Financing VIInternal Financing

    Short-Term Financing VIInternal Financing

    Short-Term Financing VIIInternal Financing


    • Just-in-Time

    • Japanese stock control technique

    • Stock timed to arrive just before use

    • But no stock buffer for unexpected emergencies

    Short-Term Financing VIIIExternal Financing

    • Cash

    • Borrow from bank via loans or overdrafts

    • Debtors

    • Debt Factoring

    • Subcontract debtors to debt factoring companies

    • Company no need for credit control staff and receives an advance from debt factor

    • Debt factoring company charges for services

    • Invoice Discounting

    • In effect, a loan secured on debtors

    • Company still manages its debtors

    • Stock

    • Possible to sell and buy back stock

    Long-Term Financing I

    Long-Term Financing IIInternal Sources

    • Retained profits

    • An alternative to external financing

    • Business finances itself out of past successes

    • Shareholders trade dividends today for future growth

    Long-Term Financing IIIExternal Sources

    • Leasing

    • Same as individual hiring say T.V.

    • Asset owned by lessor, but used by company

    • Company pays lessor

    • Saves company finding capital to purchase asset

    • Company pays more than original purchase price

    • Source of assets, not source of finance

    • Share Capital

    • Raise substantial finance by share or loan capital

    • Types of share issue

      i. Rights - existing shareholders can buy more

      ii. Public - direct offer to public

      iii. Placing - place with financial institution

    Long-Term Financing IVExternal Sources

    • Loan Capital

    • Long-term borrowing

    • Loan interest an expense

    • Loans secured on assets

    • Loan holders not owners of company

    Cost of Capital I

    • Cost at which a business raises funds

    • Two sources of funds:



    • Debt normally cheaper

    • Each source of finance has an associated cost of capital

    • A business’s overall cost of capital is its weighted average cost of capital

    Cost of Capital II

    D. Ebt finances her college course as follows:

    General expenses, by credit card£3,000 at 25% interest p.a.

    Accommodation, by bank loan£4,000 at 10% interest p.a.

    Car, by loan from uncle£3,000 at 5% interest p.a.

    What is D. Ebts overall weighted average cost of capital?

    Source of ProportionCost of Weighted average

    Financecapitalcost of capital (WACC)

    £ % %

    Credit card3,0003025 7.5

    Bank loan4,0004010 4.0

    Personal loan3,00030 5 1.5


    Cost of Capital III

    Costco plc

    • 800,000 £1 ordinary shares currently quoted at £2.50 each. Dividend 20p per share.

    • £200,000 debt currently worth £1,000,000. Loan interest £60,000.

      Calculate Costco plc’s weighted average cost of capital.

      Source ofMarketProportionCost ofWeighted average

      financevalue %capital cost of capital

      Equity £2,000,000 66.67 8%* 5.33%

      Debt £1,000,00033.33 6%** 2.00%


      * (£0.20÷£2.50)


      Helpnote: We need market value not original cost


    • Sources of finance essential

    • Short-term sources of finance (cash, debtors and stock)

    • Long-term sources of capital fund infrastructure activities

    • Four main long-term sources: retained profits, leasing, share capital and loan capital

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