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NCERT Solutions for Class 11th: Ch 8 Sources of Business Finance
Business Studies Page No: 205
Exercises
Multiple Choice Questions:
Tick (✓) the correct answer out of the given alternatives
1. Equity shareholder are called
(a) Owners of the company
(b) Partners of the company
(c) Executives of the company
(d) Guardian of the company
► (a) Owners of the company
2. The term 'redeemable' is used for
(a) Preference shares
(b) Commercial paper
(c) Equity shares
(d) Public deposits
► (a) Preference shares
3. Funds required for purchasing current assets is an example of
(a) Fixed capital requirement
(b) Ploughing back of profits
(c) Working capital requirement
(d) Lease financing
► (c) Working capital requirement
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4. ADRs are issued in
(a) Canada
(b) China
(c) India
(d) USA
► (d) USA
5. Public deposits are deposits that are raised directly from
(a) The public
(b) The directors
(c) The auditors
(d) The owners
► (a) The public
6. Under the lease agreement, the lessee gets the right to
(a) Share profits earned by the lessor
(b) Participate in the management of the organisation
(c) Use the asset for a specific period
(d) Sell the assets
► (c) Use the asset for a specific period
7. Debentures represent
(a) Fixed capital of the company
(b) Permanent capital of the company
(c) Fluctuating capital of the company
(d) Loan capital of the company
► (d) Loan capital of the company
8. Under the factoring arrangement, the factor
(a) Produces and distributes the goods or services
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(b) Makes the payment on behalf of the client
(c) Collects the client's debt or account receivables
(d) Transfer the goods from one place to another
► (c) Collects the client's debt or account receivables
9. The maturity period of a commercial paper usually ranges from
(a) 20 to 40 days
(b) 60 to 90 days
(c) 120 to 365 days
(d) 90 to 364 days
► (d) 90 to 364 days
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10. Internal sources of capital are those that are
(a) generated through outsiders such as suppliers
(b) generated through loans from commercial papers
(c) generated through issue of shares
(d) generated within the business
► (d) generated within the business
Short Answer Questions
1. What is business finance? Why do businesses need funds? Explain.
Answer
The requirements of funds by business to carry out its various activities
is called business finance.
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The business need funds for:
→ Fixed capital requirements: In order to start business, funds are
required to purchase fixed assets like land and building, plant and
machinery, and furniture and fixtures. The funds required in fixed assets
remain invested in the business for a long period of time.
→ Working Capital requirements: Firms require funds for financing their
day-to-day operations such as purchase of raw materials and payment
of wages to workers. The requirement of funds for such operations is
known as the working capital requirement.
2. List sources of raising long-term and short-term finance.
Answer
Sources of long-term-finance are:
• Equity shares
• Retained earnings
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• Preference shares
• Debentures
• Loans from financial institutions
• Loan from Banks
Sources of short-term-finance
• Trade credit
• Factoring
• Banks
• Commercial paper
3. What is the difference between the internal and external sources of
raising funds? Explain.
Answer
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Internal Sources External Sources
External sources of funds includes
Internal sources of funds are those source that lie outside the
those that are generated within a organisation such as the suppliers,
business. creditors, investors, banks and
financial institutions.
Accelerating collection of
Issue of debentures, borrowing from
receivables, disposing of surplus
commercial banks and financial
inventories and ploughing back
institutions and accepting public
of profit are examples of these
deposits are examples of these funds.
funds.
The internal sources of funds can
Large amount of money can be raised
only fulfill limited needs of the
through external sources.
business.
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4. What preferential rights are enjoyed by preference shareholders?
Explain.
Answer
The preference shareholders enjoy a preferential position over equity
shareholders by:
→ They receive a fixed rate of dividend, out of the net profits of the
company, before any dividend is declared for equity shareholders;
→ They receive their capital after the claims of the company’s creditors
have been settled, at the time of liquidation.
5. Name any three special financial institutions and state their
objectives.
Answer
Financial institutions and their objectives:
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→ Industrial Finance Corporation of India (IFCI): Its objectives include
assistance towards balanced regional development and encouraging
new entrepreneurs to enter into the priority sectors of the economy.
IFCI has also contributed to the development of management education
in the country.
→ Unit Trust of India (UTI): The basic objective of UTI is to mobilise the
community’s savings and channelise them into productive ventures.
Therefore, it sanctions direct assistance to industrial
concerns, invests in their shares and debentures, and participates with
other financial institutions.
→ Industrial Credit and Investment Corporation of India (ICICI): It assists
the creation, expansion and modernisation of industrial enterprises
exclusively in the private sector. The corporation has also encouraged
the participation of foreign capital in the country.
6. What is the difference between GDR and ADR? Explain.
Answer
Global Depository Receipts (GDR) are the depository receipts
denominated in US dollars issued by depository bank to which the local
currency shares of a company are delivered. GDR is a negotiable
instrument and can be traded freely like any other security. In the Indian
context, a GDR is an instrument issued abroad by an Indian company to
raise funds in some foreign currency and is listed and traded on a
foreign stock exchange.
American Depository Receipts (ADR) are depository receipts issued by a
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company in the USA. ADRs are bought and sold in American markets like
regular stocks. ADR is similar to a GDR except that it can be issued only
to American citizens and can be listed and traded on a stock exchange of
USA.
Long Answer Questions
1. Explain trade credit and bank credit as sources of short-term finance
for business enterprises.
Answer
Trade credit is the credit extended by one trader to another for the
purchase of goods and services. Trade credit facilitates the purchase of
supplies without immediate payment. Trade credit is
commonly used by business organisations as a source of short-term
financing. It is granted to those customers who have reasonable amount
of financial standing and goodwill.
• Merits of trade credit as a source of short-term finance:
→ Trade credit helps a company to finance the accumulation of
inventories for meeting future increase in sales.
→ As the trade creditors do not have any rights over the assets of the
company, it can mortgage its assets to raise money from other sources.
• Demerits of trade credit as a source of short-term finance:
→ Easy availability of trade credit can result in overtrading, which in turn
increases the future liabilities of the buyer.
→ The amount of funds that can be generated through trade credit is
limited to the financial capacity of the supplier or the creditor.
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Bank credit: Banks all over the world extend foreign currency loans for
business purposes. They are an important source of financing non-trade
international operations. The types of loans and services provided by
banks vary from country to country.
• Merits of bank credit as a source of short-term finance:
→ Banks maintain secrecy over information related to their customers.
→ Bank credit provides flexibility to the borrower as the borrower can
increase or decrease the amount of loan according to the business
needs.
• Demerits of bank credit as a source of short-term finance:
→ It is difficult to increase the loan.
→ The terms imposed by banks are often very restrictive as example,
the bank that has granted a loan may restrict the sale of goods
mortgaged to it by the borrower.
2. Discuss the sources from which a large industrial enterprise can raise
capital for financing modernisation and expansion.
Answer
Many financial institutions are created both by central and state
governments for financing is when
large funds are required for expansion, reorganisation and
modernisation of the enterprise. These are:
→ Industrial Finance Corporation of India (IFCI): It was established in July
1948 as a statutory corporation under the Industrial Finance
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Corporation Act, 1948. Its objectives include assistance towards
balanced regional development and encouraging new entrepreneurs to
enter into the priority sectors of the economy. IFCI has also contributed
to the development of management education in the country.
→ State Financial Corporations (SFC): The State Financial Corporations
Act, 1951 empowered the State Governments to establish State
Financial Corporations in their respective regions for providing medium
and short term finance to industries which are outside the scope of the
IFCI. Its scope is wider than IFCI, since the former covers not only public
limited companies but also private limited companies, partnership firms
and proprietary concerns.
→ Industrial Credit and Investment Corporation of India (ICICI): This was
established in 1955 as a public limited company under the Companies
Act. ICICI assists the creation, expansion and modernisation of industrial
enterprises exclusively in the private sector. The corporation has also
encouraged the participation of foreign capital in the country.
→ Industrial Development Bank of India (IDBI): It was established in
1964 under the Industrial Development Bank of India Act, 1964 with an
objective to coordinate the activities of other financial institutions
including commercial banks. The bank performs three types of
functions, namely, assistance to other financial institutions, direct
assistance to industrial concerns, and promotion and coordination of
financial-technical services.
→ State Industrial Development Corporations (SIDC): Many state
governments have set up State Industrial Development Corporations for
the purpose of promoting industrial development in their respective
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states. The objectives of the SIDCs differ from one state to another.
→ Unit Trust of India (UTI): It was established by the Government of
India in 1964 under the Unit Trust of India Act, 1963. The basic objective
of UTI is to mobilise the community’s savings and channelise them into
productive ventures. For this purpose, it sanctions direct assistance to
industrial concerns, invests in their shares and debentures, and
participates with other financial institutions.
→ Industrial Investment Bank of India Ltd.: It was initially set up as a
primary agency for rehabilitation of sick units and was known as
Industrial Reconstruction Corporation of India. It was reconstituted and
renamed as the Industrial Reconstruction Bank of India in 1985 and
again in 1997 its name was changed to Industrial Investment Bank of
India. The Bank assists sick units in the reorganisation of their share
capital, improvement in management system, and provision of finance
at liberal terms.
→ Life Insurance Corporation of India (LIC): LIC was set up in 1956 under
the LIC Act, 1956 after nationalising 245 existing insurance companies. It
mobilises the community’s savings in the form of insurance premia and
makes it available to industrial concerns, both public as well as private,
in the form of direct loans and underwriting of and subscription to
shares and debentures.
3. What advantages does issue of debentures provide over the issue of
equity shares?
Answer
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Debentures are long term debts by which a company can raise funds
which bear a fixed rate of interest. The debenture issued by a company
is an acknowledgment that the company has borrowed a certain amount
of money, which it promises to repay at a future date.
The advantage of issue of debentures over the issue of equity shares
are:
→ The issue of equity shares means dilution of ownership of a firm while
debentures holders do not have any rights in the company. They do not
enjoy voting rights or any kind of ownership in the firm. They are only
entitled to a fixed amount as payment.
→ For issuing shares a company has to incur huge costs. Also, it has to
pay dividends to its shareholders, which are not tax deductible while a
company receives tax deductions on the interest paid to its debenture
holders. Therefore, issuing debentures is advantageous for a firm in
terms of low costs.
→ Debentures carry a fixed rate of return which means that irrespective
of the profit earned, the company has to pay only a fixed interest to its
debenture holders while a company that issues shares has to pay
dividends to the shareholders, which varies with the profit i.e., the
higher the profit, the higher will be the dividends.
4. State the merits and demerits of public deposits and retained
earnings as methods of business finance.
Answer
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Public Deposits
The deposits that are raised by organisations directly from the public are
known as public deposits. Rates of interest offered on public deposits
are usually higher than that offered on bank deposits. Any person who is
interested in depositing money in an organisation can do so by filling up
a prescribed form. The organisation in return issues a deposit receipt as
acknowledgment of the debt.
• Merits of Public deposits are:
→ The procedure of obtaining deposits is simple and does not contain
restrictive conditions as are
generally there in a loan agreement
→ Cost of public deposits is generally lower than the cost of borrowings
from banks and financial
institutions
→ Public deposits do not usually create any charge on the assets of the
company. The assets can be used as security for raising loans from other
sources
→ As the depositors do not have voting rights, the control of the
company is not diluted.
• Demerits of Public deposits are:
→ New companies generally find it difficult to raise funds through public
deposits
→ It is an unreliable source of finance as the public may not respond
when the company needs money
→ Collection of public deposits may prove difficult, particularly when the
size of deposits required is large.
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Retained earnings
Business enterprise keep a portion of the net earnings may be retained
in the business for use in the future. This is known as retained earnings.
It is a source of internal financing or self- financing or ‘ploughing back of
profits’.
• Merits of Retained earnings are:
→ Retained earnings is a permanent source of funds available to an
organisation
→ It does not involve any explicit cost in the form of interest, dividend
or floatation cost
→ As the funds are generated internally, there is a greater degree of
operational freedom and flexibility
→ It enhances the capacity of thebusiness to absorb unexpected losses;
→ It may lead to increase in the market price of the equity shares of a
company.
• Demerits of Retained earnings are:
→ Excessive ploughing back may cause dissatisfaction amongst the
shareholders as they would get lower dividends;
→ It is an uncertain source of funds as the profits of business are
fluctuating;
→ The opportunity cost associated with these funds is not recognised by
many firms. This may lead to sub-optimal use of the funds.
5. Discuss the financial instruments used in international financing.
Answer
The financial instruments used in international financing are:
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→ Global Depository Receipts (GDRs): These are receipts issued by
depository banks against the shares of a company. Such depository
receipts denominated in US dollars are known as Global Depository
Receipts (GDR). GDR is a negotiable instrument and can be traded freely
like any other security. In the Indian context, a GDR is an instrument
issued abroad by an Indian company to raise funds in some foreign
currency and is listed and traded on a foreign stock exchange.
→ American Depository Receipts (ADR’s): The depository receipts issued
by a company in the USA are known as American Depository Receipts.
ADRs are bought and sold in American markets like regular stocks. It is
similar to a GDR except that it can be issued only to American citizens
and can be listed and traded on a stock exchange of USA.
→ Foreign Currency Convertible Bonds (FCCBs): These bonds are debt
securities that are convertible into equity shares or depository receipts
after a specific period of time. The terms and prices of such conversions
are generally specified in advance. The return on such securities is pre-
fixed and lower than the return on non-convertible securities.
6. What is a commercial paper? What are its advantages and limitations.
Answer
Commercial paper is an unsecured promissory note issued by a firm to
raise funds for a short period, varying from 90 days to 364 days. It is
issued by one firm to other business firms, insurance companies,
pension funds and banks. The amount raised by CP is generally very
large. As the debt is totally unsecured, the firms having good credit
rating can issue the CP. Its regulation comes under the purview of the
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Reserve Bank of India.
• Advantages of Commercial paper are:
→ A commercial paper is sold on an unsecured basis and does not
contain any restrictive conditions;
→ As it is a freely transferable instrument, it has high liquidity;
→ It provides more funds compared to other sources. Generally, the
cost of CP to the issuing firm is lower than the cost of commercial bank
loans;
→ A commercial paper provides a continuous source of funds. This is
because their maturity can be tailored to suit the requirements of the
issuing firm. Further, maturing commercial paper can be repaid by
selling new commercial paper;
→ Companies can park their excess funds in commercial paper thereby
earning some good return on the same.
• Limitations of Commercial paper are:
→ Only financially sound and highly rated firms can raise money
through commercial papers. New and moderately rated firms are not in
a position to raise funds by this method.
→ The size of money that can be raised through commercial paper is
limited to the excess liquidity available with the suppliers of funds at a
particular time;
→ Commercial paper is an impersonal method of financing. As such if a
firm is not in a position to redeem its paper due to financial difficulties,
extending the maturity of a CP is not possible
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