Sources of Funds case Essay Example | Topics and Well Written Essays - 500 words

Sources of Funds case - Essay Example Equity can be generated internally as retained earnings or generated externally generated as common share capital. A company may choose to use its retained earnings to expand its operations. This is because the cost of retained earnings is relatively lower compared to the cost of common share capital. The major drawbacks of this source of finance are that it is usually inadequate, and its use can easily expose a company to liquidity problems. Consequently, a firm can source equity through issuing of common shares. This source of funds confers several advantages. The first advantage is that this form of financing is a permanent source of capital because common shares have no maturity date. The company does not have any liability for cash outflows linked with the redemption of the common shares. This facilitates financing of long term projects. Secondly use of equity lowers the gearing level hence a company has a broader borrowing capacity. Thirdly, the shareholders may provide valuabl e ideas to the company’s operations. However, this method faces various drawbacks. First the floatation costs are higher than those of debt (Pratt, 2010). Secondly, equity is only accessible to companies that have fulfilled the capital markets authority requirements. Thirdly, it can lead to dilution of ownership of control of the firm by the shareholders. The second method of raising capital is debt capital. This form of capital can be in the form of debentures and corporate bonds. This source of funds confers several advantages. Firstly, the floatation costs are lower than those of common share capital. Secondly, since the interest on debt is tax allowable then the company enjoys a tax saving. This method of raising capital also faces various drawbacks. Default in payment of principal and interest can force a company into liquidation. Secondly, Providers of debt capital impose conditions, and many restrictive covenants hence it