Q.What factors should a business consider while choosing an appropriate source of finance?

This concluding essay question of the AP BIEAP Commerce chapter tests whether a student can apply everything learnt about sources to an actual financing decision.

Choosing an appropriate source of finance is not a random decision; a firm weighs several factors together, and applies one guiding rule above all others.

The most important rule is that the period for which a source is available should match the period for which the funds are needed. Fixed assets, which remain in the business for many years, should be financed from long-term sources such as equity, preference capital, retained earnings, debentures or long-term loans, since financing them with a short-term source like a bank overdraft would expose the firm to a demand for repayment long before the asset has paid for itself. A genuinely short-term, recurring need, such as holding extra seasonal stock, is instead best met through trade credit, an overdraft or cash credit.

Beyond period-matching, several further factors matter. The cost of the source is important, since owned funds like equity involve no fixed charge but tend to be more expensive to raise, while borrowed funds carry a fixed but often lower cost. The risk involved matters too, since a heavier reliance on borrowed funds raises the fixed interest and repayment burden a firm must meet even in a poor year, whereas owned funds carry no such compulsion. The effect on ownership and control must be weighed, since a fresh equity issue can dilute existing shareholders' voting power while preference shares, debentures and loans generally do not. …