Question 4 (25 marks)
4.1 Discuss the THREE (3) Working Capital Financing policies ( 9marks)
4.2 Discuss the following sources of long-term financing for a business:
4.2.1 Ordinary and preference shares (10 marks)
4.2.2 Debentures (secured and unsecured) (7 mark
4.1 Working Capital Financing Policies:
1. Conservative Policy: A conservative working capital financing policy involves maintaining higher levels of current assets to cover short-term obligations. This policy aims to minimize risk and ensure liquidity, even if it means sacrificing some potential profitability. This can be achieved through using long-term financing options or retaining earnings to fund operations.
2. Aggressive Policy: An aggressive working capital financing policy involves maintaining lower levels of current assets to maximize profitability. This approach typically involves using short-term financing options to fund operations, such as trade credit or short-term bank loans. While this policy can lead to increased profitability, it also carries higher risk due to potential liquidity issues.
3. Moderate Policy: A moderate working capital financing policy strikes a balance between liquidity and profitability. It involves maintaining a mix of current assets and liabilities that ensures sufficient liquidity to meet short-term obligations while also leveraging debt to finance operations. This policy aims to optimize the use of capital to support business growth and profitability without taking on excessive risk.
4.2 Sources of Long-term Financing:
4.2.1 Ordinary and Preference Shares:
- Ordinary shares represent ownership in a company and provide shareholders with voting rights and dividends. These shares do not have a fixed dividend rate and can fluctuate based on the company's performance.
- Preference shares, on the other hand, have a fixed dividend rate and take priority over ordinary shares in terms of dividend payments and liquidation proceeds. Preference shareholders do not typically have voting rights but receive guaranteed dividend payments.
4.2.2 Debentures (secured and unsecured):
- Debentures are long-term debt instruments issued by a company to raise capital. Secured debentures are backed by specific assets of the company, providing security to debenture holders in case of default.
- Unsecured debentures, on the other hand, are not backed by specific assets and rely on the company's creditworthiness to attract investors. They typically carry higher interest rates compared to secured debentures due to the increased risk for investors.
Overall, the choice between different long-term financing options depends on the company's financial needs, risk tolerance, and capital structure goals. Each option has its own benefits and drawbacks, and companies must carefully consider their financing needs before choosing the most suitable option.