Q.Explain the classification of sources of corporate finance.

The underlined word is wrong. The correct word is long — a bond is a source of long-term finance.

Sources of finance are classified by the period for which the funds are required: short-term (up to 1 year, e.g. bank overdraft, trade credit), medium-term, and long-term (e.g. shares, debentures, bonds, long-term loans).

A bond is a debt instrument on which the company promises to pay a fixed rate of interest and to repay the principal after a stated, usually lengthy, period. Because the funds are used for long-term needs and repaid only after several years, a bond is a long-term source of finance.

On borrowed capital a company pays interest — a fixed charge that must be paid regardless of profit. Dividend is the return on owned capital and is paid only out of profit; discount is a price reduction, not a return on capital.

A company's total capital is broadly of two kinds:

• Owned capital — raised by issuing equity and preference shares and by ploughing back retained earnings. The reward on owned capital is dividend, which is paid only when profits are available and, for equity, is not fixed.
• Borrowed capital — raised from outsiders through debentures, bonds, public deposits and loans from banks and financial institutions. The reward on borrowed capital is interest.

Interest differs from dividend in important ways: it is paid at a fixed rate, it is a charge against profit (an expense) and not an appropriation of profit, and it must be paid even if the company makes a loss because lenders are creditors, not owners.

The underlined "internal" is wrong; deposits are an external source of finance.

On the basis of ownership/origin, sources of finance are classified as:

• Internal sources: funds generated within the business, chiefly retained earnings (ploughing back of profits) and depreciation reserves.
• External sources: funds raised from outside the business — shares, debentures, bonds, loans and public deposits.

Because deposits are money accepted from members or the public (outsiders), they are clearly an external source of financing.

The odd one out is Retained earnings, because it is an owned/internal source while the other two are borrowed sources.

Sources of corporate finance can be grouped as owned capital and borrowed capital, and also as internal and external sources. Debentures represent loans raised by issuing debt instruments, and public deposits are money borrowed from the public for a short period. Both are borrowed, external sources on which the company pays a fixed interest.

Retained earnings, on the other hand, are the profits the company keeps back instead of distributing as dividend. They belong to the company itself, are internally generated, and carry no fixed cost of interest. This makes retained earnings the odd one out among the three.

The word 'temporary' is wrong; the correct word is permanent.

Owned capital is the money contributed by the owners of the company, mainly through equity and preference shares, together with reserves built from profits. This money is not repayable during the normal life of the company; the shareholders get it back only if the company is wound up. Because it stays invested for the entire life of the company, owned capital is called permanent capital.

Borrowed capital, such as debentures, loans and deposits, is the one that is temporary, since it must be repaid after a fixed period. So describing owned capital as temporary is incorrect.