NCERT solutions class 11 Business Studies Chapter 8 Sources of Business Finance

 As chapter 7 of NCERT Book is not in syllabus of CBSE, We have skiped the question answer section for that chapter.

Chapter 8: Sources of Business Finance

Part I: Short Answer Questions

1. What is business finance? Why do businesses need funds? Explain. Concept of Business Finance

Business finance refers to the money or capital required by an enterprise for carrying out its various business activities. Without adequate finance, no business can function, survive, or grow.

Why Businesses Need Funds:

1. Fixed Capital Requirements: Funds are needed to purchase fixed assets like land, building, plant, and machinery to start and operate the business.
2. Working Capital Requirements: Funds are required for day-to-day operations, such as purchasing raw materials, paying salaries, taxes, and utility bills.
3. Diversification and Expansion: Funds are vital for upgrading technology, launching new products, or opening branches in new markets.

2. List sources of raising long-term and short-term finance. Classification of Financial Sources Long-Term Sources (More than 5 years):

• Equity Shares
• Preference Shares
• Retained Earnings
• Debentures
• Long-term loans from Financial Institutions and Commercial Banks

Short-Term Sources (Less than 1 year):

• Trade Credit
• Commercial Paper
• Bank Credit (Overdraft, Cash Credit, Discounting of Bills)
• Factoring

3. What is the difference between internal and external sources of raising funds? Explain. Internal vs. External Sources

Internal Sources: These are funds generated from within the business itself. It is a highly reliable source and does not involve fixed financial obligations or collateral.
Examples: Retained earnings, accelerating collection of receivables, and disposing of surplus inventories.

External Sources: These are funds raised from outside the organization, bringing in fresh capital. These sources usually carry a cost (like interest or dividends) and may require mortgaging company assets.
Examples: Issuing shares and debentures, borrowing from banks, and accepting public deposits.

4. What preferential rights are enjoyed by preference shareholders. Explain. Rights of Preference Shareholders

Preference shareholders are those who hold preference shares of a company. As the name suggests, they enjoy two major "preferential" rights over equity shareholders:

1. Right to Dividend: They have the right to receive a fixed rate of dividend out of the net profits of the company before any dividend is declared or paid to the equity shareholders.
2. Right to Repayment of Capital: At the time of winding up or liquidation of the company, they have the right to be repaid their capital before any capital is returned to the equity shareholders.

5. Name any three special financial institutions and state their objectives. Specialized Financial Institutions

1. Industrial Finance Corporation of India (IFCI): Its primary objective is to provide long-term and medium-term finance to industrial enterprises to assist in their modernization and expansion.
2. State Financial Corporations (SFCs): Established at the state level, their objective is to provide medium and short-term financial assistance exclusively to small and medium-scale industries within their respective states.
3. Industrial Credit and Investment Corporation of India (ICICI): Its objective is to assist the creation, expansion, and modernization of industrial enterprises exclusively in the private sector.

6. What is the difference between GDR and ADR? Explain. Global Depository Receipts (GDR) vs. American Depository Receipts (ADR)

Both are instruments used by a company to raise capital in foreign currency, but they differ in their operational market:

• GDR (Global Depository Receipt): These are depository receipts issued by an international depository bank representing foreign company's stock. They can be traded on stock exchanges in any country except the USA (most commonly traded on the London Stock Exchange).
• ADR (American Depository Receipt): These are depository receipts issued strictly by a US depository bank and can only be traded on American stock exchanges (like NYSE or NASDAQ). They are subject to strict regulations by the US Securities and Exchange Commission (SEC).

Part II: Long Answer Questions

1. Explain trade credit and bank credit as sources of short-term finance for business enterprises. Sources of Short-Term Finance 1. Trade Credit:

Trade credit is the credit extended by one trader to another for the purchase of goods and services. It is an informal arrangement where goods are delivered immediately, but payment is delayed to a future date (e.g., 30 or 60 days).

• Merits: It is a convenient and continuous source of funds. It does not require any asset to be mortgaged, and it naturally promotes sales growth.
• Demerits: It is only available for short periods, and the easy availability might induce a firm to over-trade and accumulate excessive debt.

2. Bank Credit:

Commercial banks provide short-term financial assistance to businesses through various instruments. This is the most widely used source of working capital.

• Forms of Bank Credit: It takes the form of an Overdraft (allowing the client to overdraw their current account), Cash Credit (borrowing up to a specified limit against stock), and Discounting of Bills (banks encashing bills of exchange before their maturity date).
• Merits: It provides high flexibility (funds can be borrowed exactly when needed), and the business can maintain secrecy as banking details are confidential.

2. Discuss the sources from which a large industrial enterprise can raise capital for financing modernisation and expansion. Financing Expansion and Modernisation

Modernization and expansion require massive amounts of long-term capital. A large industrial enterprise can utilize the following sources:

1. Equity Shares: This is the most fundamental source of permanent capital. It involves issuing shares to the public. There is no fixed burden to pay dividends, making it ideal for high-cost, long-term expansion projects.
2. Debentures: For businesses with steady cash flows, issuing debentures is an excellent way to raise borrowed capital. It provides long-term funds without diluting the control of existing shareholders.
3. Loans from Financial Institutions: Specialised institutions like IFCI, LIC, and IDBI provide massive long-term loans specifically meant for industrial modernization. They often provide technical and managerial assistance alongside the funds.
4. Retained Earnings: A large, profitable enterprise can "plough back" its past profits to finance its growth. This is the cheapest source of finance as there is no explicit cost of issuing funds.
5. Euro Issues (GDRs/ADRs): If the enterprise has a massive global vision, it can tap into international financial markets by issuing Global or American Depository Receipts to raise foreign capital.

3. What advantages does issue of debentures provide over the issue of equity shares? Strategic Advantages of Debentures

Raising funds through debentures (borrowed capital) provides several distinct advantages over issuing equity shares (owner's capital):

1. No Dilution of Control: Debenture holders are creditors, not owners. They do not possess voting rights, ensuring that the control of the company remains strictly with the existing equity shareholders.
2. Tax Benefits: The interest paid to debenture holders is considered a tax-deductible expense, which legally reduces the income tax liability of the company. Dividends paid on equity shares do not enjoy this benefit.
3. Trading on Equity: Because debentures carry a fixed rate of interest, during periods of high profit, the company can pay off the fixed interest and leave a massively larger residual surplus for the equity shareholders, boosting their Earnings Per Share (EPS).
4. Cheaper Source of Finance: Investors view debentures as a safer investment than equity (due to fixed returns and asset security), so they generally accept a lower rate of return, making it a cheaper source of funds for the company.
5. Flexibility: Debentures can be redeemed (paid back) when the company has surplus funds, whereas equity shares generally represent a permanent capital burden until liquidation.

4. State the merits and demerits of public deposits and retained earnings as methods of business finance. I. Public Deposits

Public deposits refer to the deposits that are raised directly by organizations from the general public for medium and short-term requirements.

Merits:

• Simple and Cost-Effective: The procedure to raise public deposits is much simpler and cheaper than the rigorous process of issuing shares or bank loans.
• No Charge on Assets: They are generally unsecured, leaving the company's assets free to be used as collateral for taking other bank loans.
• No Dilution of Control: Depositors do not get voting rights, ensuring the existing management retains full control.

Demerits:

• Fair-Weather Friend: It is an unreliable source. The public may panic and stop depositing, or prematurely withdraw funds during times of economic distress.
• Unsuitable for New Firms: New companies with no track record of profitability cannot easily attract public deposits.

II. Retained Earnings

Retained earnings (or Ploughing Back of Profits) refer to the portion of net earnings that is not distributed as dividends but retained in the business for future use.

Merits:

• Permanent and Free of Charge: It is a permanent source of funds that carries no explicit cost like interest, dividend payouts, or floatation costs (e.g., prospectus printing).
• Operational Freedom: Using internal funds provides a higher degree of operational freedom and flexibility, as there are no external creditors laying down restrictive conditions.
• Financial Resilience: It significantly enhances the capacity of the business to absorb unexpected financial shocks.

Demerits:

• Shareholder Dissatisfaction: Excessive retention of profits leads to lower dividend payouts, which can cause dissatisfaction among existing shareholders and drop the market price of the shares.
• Uncertainty: It is an uncertain source of finance because it directly depends on the erratic nature of annual business profits.
• Opportunity Cost Ignored: Management might use retained earnings carelessly on unprofitable projects because there is no immediate pressure to pay interest to an external party.