Question

1. Assume that Catherine Mahugu of Soko plans on expanding her business to accommodate more product lines. She is considering financing here expansion in one of two ways: (1) contributing more of her own funds to the business or (2) borrowing the funds from her bank.

a. Identify at least 2 issues that Catherine should consider when trying to decide on the method for financing the expansion. What are the pros and cons of each method?

b. Can you think of 2 other ways to finance this expansion? What are the pros and cons of each method?

2. Lisa Corentine is an aspiring entrepreneur and your friend. She is having difficulty understanding the purposes of each financial statement and how they fit together across time.

a. Write a one-page memo to her explaining the main purposes of each financial statement and how they are linked across time.

Answer 1

1 (a) Following issues Catherine should consider while trying to decide on the financing expansion under two different methods opted by her.

1. Method -1 – Contribution of own fund.
   1. Return on investment vs. return from business – Catherine must compare the % of return which she is getting from investments of her funds and what % of return she is going to get from the business explanation. And the return from business must be higher than the investment.
   2. Contingency fund to meet personal requirements - Catherine must ensure that she has enough money left over to cover regular living costs and should try to leave a contingency fund, in case of need of extra money through a difficult period.
2. Method -2 - borrowing the funds from bank.
   1. Security - loans are generally secured against the assets of the business or personal possessions. Hence Catherine must ensure that she has enough assets to mortgage against the loan.
   2. Utilization of Loan Funds - Generally Loans are not very flexible and interest needs to be paid to banks even though funds are not utilized. Hence Catherine must ensure that loan has been taken only for the required amount.

Pros and cons of above two methods

1. Method -1 – Contribution of own fund.
   1. Contribution to own funds will retain full ownership and there will be no involvement of bankers in the business. It will result in time saving and hassle free business operation
   2. Flexibility of putting and withdrawing the funds as per business needs.
   3. If business were to fail all the personal funds could be lost.
2. Method -2 - borrowing the funds from bank
   1. Loan is not repayable on demand so the funds can be available for business for longer period unless you breach the loan conditions.
   2. Interest payment on loans can be claimed as expenses for income tax purpose and hence there will be saving In income tax.
   3. Loans are generally secured against the assets of the business or personal possessions. Hence Catherine must ensure that she has enough assets to mortgage against the loan.
   4. Loans will have certain terms and conditions or covenants that you must adhere to, such as the provision of quarterly management information.
   5. Bankers may charge additional fees for Prepayment of loan.

Followings are 2 other ways to finance this expansion which Catherine may look into

1. Funding from Capital Markets.
2. Government Assistance.

1. Pros and cons of Funding from Capital Markets

1. Saving of fixed interest cost.
2. Support from the investors will be received who has vested interest in the business thorugh equity financing. And there will be more opportunity for growth.
3. Time consuming process to raise the fund.
4. Regulatory issues needs to be complied at the time of funding and even on periodical basis.

2. Pros and cons of Government Assistance

1. Rate of interest could be subsidized and generally lower than borrowing funds from banks.
2. Could avail tax holidays/tax exemptions on interest costs.
3. Regulatory issues needs to be complied at the time of funding and even on periodical basis.
4. Not available for all types of business activities and its restricted to particular sector or type of business.