Section A: Key terms and recall
Name two reasons why a business might need finance. [2 marks]
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model answer: - Start-up capital - Expansion [2 marks]
What is the difference between short-term and long-term finance needs? [2 marks]
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model answer: - Short-term finance needs are for less than a year, e.g. paying suppliers or wages. - Long-term finance needs are for more than a year, e.g. buying equipment or buildings. [2 marks]
Give one example of an internal source of finance and one example of an external source of finance. [2 marks]
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model answer: - Internal: Retained profit - External: Bank loan [2 marks]
What is the difference between debt and equity finance? [2 marks]
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model answer: - Debt finance is money borrowed that must be repaid, often with interest. - Equity finance is money invested in a business in exchange for a share of ownership. [2 marks]
Name two alternative sources of capital. [2 marks]
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model answer: - Micro-finance - Crowd-funding [2 marks]
Section B: Applying your knowledge
A small bakery wants to buy new equipment to increase production. It needs 20,000 USD. Recommend and justify an appropriate source of finance. [3 marks]
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model answer: - Bank loan: The bakery could take out a long-term loan to pay for the equipment. This would allow the business to repay the loan over time as it generates more revenue from increased production. [3 marks]
A retail shop has a short-term cash flow problem. It needs 5,000 USD for the next three months. Recommend and justify an appropriate source of finance. [3 marks]
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model answer: - Overdraft: The shop could arrange an overdraft facility with its bank. This would provide the business with immediate access to the funds it needs and would be repaid once the business has more cash available. [3 marks]
A manufacturing business wants to expand into a new market. It needs 500,000 USD. Recommend and justify an appropriate source of finance. [3 marks]
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model answer: - Equity finance: The business could issue new shares to raise the capital it needs. This would allow the business to share the risk of the expansion with new shareholders and would not require the business to make regular repayments. [3 marks]
A service business has a legal form of a sole trader and needs 10,000 USD to renovate its premises. Recommend and justify an appropriate source of finance. [3 marks]
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model answer: - Personal savings: The sole trader could use their personal savings to finance the renovation. This would avoid the business taking on debt or giving up ownership. [3 marks]
Section C: Explain and analyse
Explain the importance of considering the size and legal form of a business when choosing a source of finance. [4 marks]
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model answer: - The size of the business will determine how much finance it needs and its ability to repay the finance. A larger business may be able to access more sources of finance, such as issuing shares or bonds. - The legal form of the business will determine its ownership structure and liability. For example, a sole trader may be limited in the sources of finance available to them, as they have unlimited liability. A limited company may be able to access more sources of finance, as shareholders have limited liability. [4 marks]
Analyse the factors that a business might consider when choosing between debt and equity finance. [5 marks]
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model answer: - Amount required: Debt finance may be more suitable for smaller amounts, as it does not dilute ownership. Equity finance may be more suitable for larger amounts, as it does not require regular repayments. - Length of time: Debt finance may be more suitable for short-term needs, as it can be repaid quickly. Equity finance may be more suitable for long-term needs, as it does not have a repayment date. - Interest rates: The business should consider the current interest rates and how they will affect the cost of debt finance. - Risk: Debt finance may be riskier, as the business is required to make regular repayments regardless of its profitability. Equity finance may be less risky, as the business is not required to make repayments. - Control: The business should consider how much control it is willing to give up in exchange for finance. Debt finance does not dilute ownership, while equity finance does. [5 marks]
Section D: Challenge
A business is considering two sources of finance: a bank loan or issuing new shares. The bank loan would have an interest rate of 5% and would be repaid over five years. Issuing new shares would dilute the ownership of the existing shareholders but would not require any repayments. The business needs 100,000 USD and wants to minimise its financial risk. Recommend and justify the most appropriate source of finance. [6 marks]
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model answer: - The business should consider the following factors: - Amount required: Both sources of finance could provide the business with the 100,000 USD it needs. - Length of time: The bank loan would be repaid over five years, while the new shares would not have a repayment date. - Interest rates: The bank loan would have an interest rate of 5%, which would add to the business's financial risk. - Risk: The bank loan would require regular repayments, regardless of the business's profitability. The new shares would not require any repayments, but would dilute ownership. - Control: The bank loan would not dilute ownership, while the new shares would. - Based on these factors, the most appropriate source of finance for the business would be issuing new shares. This would allow the business to raise the finance it needs without taking on additional debt or diluting ownership too much. The business could issue a number of new shares that would raise the required amount, while minimising the dilution of ownership. [6 marks]