AQA Specification focus:
‘Students should know that ways in which firms raise finance include: issuing shares, issuing corporate bonds and borrowing from a bank.’
Firms need finance to start, grow, and sustain operations. Understanding how firms raise finance is crucial in A-Level Economics, as it shapes investment, expansion, and long-term competitiveness.
Sources of Business Finance
Firms can obtain finance from a variety of sources. The AQA specification highlights three central methods: issuing shares, issuing corporate bonds, and borrowing from banks. Each method has unique features, advantages, and drawbacks. Economists classify these broadly into internal finance (generated from within the firm) and external finance (sourced from outside the firm).
Internal vs External Finance
Internal finance: Retained profits or the sale of assets within the business.
External finance: Funds raised from shareholders, bondholders, or financial institutions.
Since the specification stresses external finance, the focus here is on shares, bonds, and bank borrowing.
Issuing Shares
A share represents part-ownership of a company. Shareholders become part-owners, with rights to dividends and voting power.
Share: A unit of ownership in a company, entitling the holder to a portion of profits and, in some cases, voting rights.
Types of Shares
Ordinary shares: Holders receive dividends depending on profit levels.
Preference shares: Fixed dividends, often with priority over ordinary shareholders.
Advantages of Issuing Shares
No obligation to repay principal.
Can raise large amounts of long-term finance.
Enhances credibility by listing on stock exchanges.
Disadvantages of Issuing Shares
Dilution of ownership and control.
Dividends can be costly if profits grow.
Compliance with regulatory and reporting requirements increases costs.
Issuing shares is often suitable for public limited companies with access to stock markets, but not usually for small private firms.
Issuing Corporate Bonds
A bond is a form of debt finance where investors lend money to the firm for a fixed period.
Corporate Bond: A debt security issued by a company promising to pay regular interest (coupon) and repay principal at maturity.
Key Terms in Bonds
Coupon: Regular interest payment made to bondholders.
Maturity: The date when the principal is repaid.
Yield: The effective rate of return for bondholders.
Advantages of Issuing Bonds
Interest costs are tax-deductible.
Does not dilute ownership.
Predictable repayment schedule.
Disadvantages of Issuing Bonds
Creates fixed financial obligations.
High interest rates if the firm is risky.
Bond issuance is usually available only to larger, established firms.
Bond financing is particularly useful for firms needing long-term capital for investment projects.
Borrowing from Banks
Banks remain a central source of finance for firms, offering loans, overdrafts, and revolving credit facilities.
Bank Loan: A sum of money borrowed from a bank, usually repaid with interest over an agreed period.
Types of Bank Finance
Short-term loans: Cover working capital needs.
Long-term loans: Finance capital investment.
Overdrafts: Flexible, short-term borrowing tied to cash flow fluctuations.
Advantages of Bank Borrowing
Quick and accessible for most firms.
Flexible repayment terms may be negotiated.
Suitable for firms without access to capital markets.
Disadvantages of Bank Borrowing
Must be repaid with interest, creating financial pressure.
Collateral may be required, increasing risk to owners.
Interest costs vary with market rates, adding uncertainty.
Bank borrowing is particularly common among small and medium-sized enterprises (SMEs).
Comparing the Three Main Methods
Ownership and Control
Shares dilute ownership but provide permanent capital.
Bonds and loans preserve ownership but increase debt obligations.
Risk
Equity finance (shares) transfers some risk to shareholders.
Debt finance (bonds, loans) obligates firms to pay interest regardless of performance.
Cost of Finance
Shares: Dividend payments are not compulsory but may be expected by investors.
Bonds: Coupon payments are fixed, often lower than dividends but inflexible.
Loans: Interest rates may fluctuate, increasing long-term cost.
Suitability
Shares: Best for large firms seeking long-term growth.
Bonds: Suitable for established companies with strong credit ratings.
Bank loans: Accessible to most firms, especially SMEs.
Additional Considerations
Matching Finance to Purpose
Economists stress the importance of matching the type of finance to the purpose of spending:
Short-term needs → bank overdrafts.
Long-term investment → bonds or share issuance.
Economic Conditions
The method chosen often depends on the wider economic climate:
In low interest rate environments, debt finance (loans, bonds) is attractive.
In times of high investor confidence, equity finance (shares) becomes easier to raise.
Financial Market Development
Advanced economies with developed financial markets provide wider access to bonds and shares. In contrast, in developing economies, firms rely heavily on bank loans.
FAQ
Firms weigh several considerations when choosing finance:
Cost of finance: Interest rates on loans vs. dividends for shareholders.
Control: Debt preserves ownership, while equity dilutes it.
Risk appetite: Firms with volatile profits may avoid fixed debt obligations.
Market conditions: Investor confidence or credit availability shape choices.
Smaller firms often lack access to stock exchanges or the credibility needed to attract investors.
High regulatory costs make issuing shares unattractive.
Bonds are generally issued by larger, established firms with strong credit ratings.
Banks remain the primary external finance source for small and medium-sized enterprises.
When interest rates are low, debt finance becomes cheaper, encouraging firms to borrow.
If rates rise, firms may turn to equity finance, even though this dilutes ownership.
Higher interest costs also reduce profitability, making long-term debt less attractive.
Firms rely on willing investors to buy new shares. Investor confidence is influenced by:
Economic growth and market optimism.
The firm’s past performance and future prospects.
Stability of dividends and return expectations.
If confidence is weak, raising finance through shares becomes difficult.
The duration of finance matters for matching funds to needs.
Short-term needs (e.g., cash flow gaps) → bank overdrafts or short-term loans.
Medium-term needs → bank loans or smaller bond issues.
Long-term investment → issuing shares or large corporate bonds.
Choosing mismatched finance increases financial risk and instability.
Practice Questions
Define the term corporate bond. (2 marks)
1 mark for recognising that a corporate bond is a form of debt.
1 mark for stating that it involves regular interest (coupon) payments and repayment of principal at maturity.
(6 marks)
Explain two advantages to a firm of raising finance by issuing shares rather than borrowing from a bank.
Up to 3 marks for each advantage explained (2 advantages required).
1 mark for identifying an advantage (e.g., no repayment obligation, access to large sums of finance, increased credibility).
1–2 marks for explaining why this is an advantage (e.g., avoids debt obligations, suitable for long-term projects, improves market perception).
Maximum 6 marks if both advantages are clearly identified and explained.
