28  Scope and sources of finance; Lease financing

28.1 Concept of Business Finance

Business finance is the activity concerned with the acquisition, allocation and management of funds by a business enterprise. The Howard and Upton definition — finance is “that administrative area which has to do with management of money and money substitutes” — captures the field. The modern finance function rests on three classical decisions: the investment decision (where to deploy funds — capital budgeting), the financing decision (where to raise funds — capital structure), and the dividend decision (how much to retain or pay out). To these is increasingly added the liquidity / working-capital decision as a fourth.

28.2 Goals of the Finance Function

TipTwo Competing Goals
Goal What it maximises Limitations addressed
Profit Maximisation Accounting profit Vague; ignores risk, time value, stakeholders
Wealth / Value Maximisation Market value of equity (NPV of future cash flows) Considers risk, time and long-term perspective

Modern corporate finance treats shareholder wealth maximisation — proxied by market value of equity — as the normative objective, while recognising stakeholder considerations.

28.3 Scope of Business Finance

TipScope — Three Classical Decisions
  • Investment decision (Capital Budgeting) — long-term commitment of funds to projects.
  • Financing decision (Capital Structure) — mix of debt and equity.
  • Dividend decision — payout vs retention.
  • Fourth: Liquidity / Working-capital management — balance of current assets and current liabilities.

28.4 Sources of Finance — Classification

TipThree Classifications of Sources
Basis Categories
Time period Long-term · Medium-term · Short-term
Ownership Owners’ funds (equity, retained earnings) · Borrowed funds (debt)
Generation Internal · External

28.4.1 Long-Term Sources

TipMajor Long-Term Sources
  • Equity shares — permanent capital; residual claim; voting rights.
  • Preference shares — fixed dividend; preferred claim on dividend and capital; can be cumulative, participating, convertible, redeemable.
  • Debentures / Bonds — debt securities; fixed interest; secured/unsecured; convertible/non-convertible.
  • Term loans — from banks and financial institutions; secured by assets.
  • Retained earnings — internal source; the cheapest form.
  • External Commercial Borrowings (ECB) — long-term debt from foreign lenders; regulated by RBI.
  • Foreign Currency Convertible Bonds (FCCBs) — debt convertible into equity.
  • GDRs / ADRs — Global / American Depository Receipts representing equity.
  • Venture capital and Private equity — start-up and growth-stage equity funding.

28.4.2 Medium-Term Sources

TipMedium-Term Sources
  • Term loans (3-10 years).
  • Lease financing — discussed below.
  • Hire-purchase.
  • Public deposits — accepted by NBFCs (regulated by RBI); from public.

28.4.3 Short-Term Sources

TipShort-Term Sources
  • Trade credit — supplier finance via credit period.
  • Bank credit — cash credit, overdraft, bill discounting, working capital loan.
  • Commercial paper — unsecured promissory note by large rated corporates (RBI regulated).
  • Certificate of Deposit — issued by banks/FIs to large depositors.
  • Factoring and Forfaiting — sale of receivables.
  • Accruals — outstanding wages, taxes.
  • Inter-corporate deposits.

28.5 Lease Financing

28.5.1 Concept

A lease is a contract by which the lessor (owner) grants the lessee (user) the right to use an asset for a specified period in exchange for periodic lease rentals. Lease financing is an alternative to outright purchase using debt or equity.

28.5.2 Types of Lease

TipTypes of Lease
Type Working content
Operating lease Short-term, lessor bears risk of ownership and maintenance; cancellable
Finance lease (Capital lease) Long-term, transfers substantially all risks and rewards to lessee; non-cancellable
Sale-and-leaseback Owner sells the asset to a lessor and leases it back
Leveraged lease Three parties — lessee, lessor, lender — lessor borrows to buy the asset
Direct lease Lessor directly buys the asset and leases it
Wet lease / Dry lease Aircraft industry — with crew (wet) or without (dry)

28.5.3 Operating vs Finance Lease (Ind AS 116 / IFRS 16)

The earlier AS 19 classification has been partly displaced for lessees under Ind AS 116 / IFRS 16 (in force from 2019) which mandates a right-of-use asset and a lease liability on the balance sheet for almost all leases — bringing former operating leases onto the balance sheet. Lessors still classify as operating or finance lease.

TipOperating vs Finance Lease — Classical Distinction
Aspect Operating Lease Finance Lease
Duration Short, much less than asset life Long, covering most of asset life
Risk of ownership Lessor Lessee
Maintenance Lessor Lessee
Cancellable Yes No
Asset on lessee’s BS (pre-Ind AS 116) No Yes
Balance-sheet impact (Ind AS 116) Right-of-use asset + lease liability Right-of-use asset + lease liability
Examples Car rentals; office equipment Industrial machinery; aircraft on long lease

28.5.4 Advantages and Disadvantages of Leasing

TipLease — Pros and Cons
Advantages Disadvantages
No large upfront cash outflow Total cost over life often higher than purchase
Off-balance-sheet (pre-Ind AS 116) No ownership; no residual value to lessee
Tax-deductible lease rentals Lessee bears risk of asset becoming obsolete (in finance lease)
Easier to acquire vs loan + buy Penalty for early termination
Aids 100 % financing Restrictive covenants

28.6 Owners’ Funds vs Borrowed Funds

TipEquity vs Debt — Owner’s vs Borrowed
Dimension Equity (Owner) Debt (Borrowed)
Claim Residual Fixed/contractual
Maturity Perpetual Limited
Return Dividends + capital gains Interest
Risk to firm Lower (no obligation) Higher (interest must be paid)
Risk to investor Higher Lower
Tax shield None on dividends Interest is tax-deductible
Control Voting rights No voting (usually)

28.7 Internal vs External Financing

TipInternal vs External Sources
  • Internal: Retained earnings; depreciation provisions.
  • External: All other sources — share issue, debt, lease, trade credit.
  • Internal financing is cheaper (no flotation cost; no obligation) but limited in amount.

flowchart TB
  F[Sources of Finance] --> L[Long-term]
  F --> M[Medium-term]
  F --> S[Short-term]
  L --> E[Equity / Preference]
  L --> D[Debentures / Term loans]
  L --> R[Retained earnings]
  L --> O[ECB / FCCB / GDR / VC-PE]
  M --> TL[Term loans / Lease / Hire-purchase / Public deposits]
  S --> TC[Trade credit / Bank credit / CP / CD / Factoring]
    classDef default fill:#003366,color:#ffffff,stroke:#ffcc00,stroke-width:3px,rx:10px,ry:10px;

28.8 Indian Regulatory Framework

TipKey Indian Regulators of Finance Sources
  • SEBI — public issue of shares and debentures; ICDR Regulations 2018.
  • RBI — ECBs, FCCBs, NBFC public deposits, commercial paper.
  • MCA — companies’ issue under Companies Act 2013; private placement (§42), rights issue (§62), bonus (§63).
  • FEMA 1999 — foreign-currency-denominated funding.
  • Stock Exchanges — listing rules.

28.9 Practice Questions

Q 01 Goal Easy

The dominant normative goal of corporate finance is:

  • AProfit maximisation
  • BSales maximisation
  • CShareholder wealth maximisation
  • DEmployee welfare maximisation
View solution
Correct Option: C
**Shareholder wealth** — proxied by market value of equity — is the modern normative objective.
Q 02 Decisions Medium

Which is **not** a classical decision of the finance function?

  • AInvestment decision
  • BFinancing decision
  • CDividend decision
  • DManufacturing process decision
View solution
Correct Option: D
Three classical decisions = investment, financing, dividend.
Q 03 Sources Medium

Match each source with its category:

Source Category
(i) Equity shares (a) Short-term
(ii) Trade credit (b) Long-term
(iii) Public deposits (3-year) (c) Medium-term
  • A(i)-(b), (ii)-(a), (iii)-(c)
  • B(i)-(a), (ii)-(b), (iii)-(c)
  • C(i)-(c), (ii)-(b), (iii)-(a)
  • D(i)-(b), (ii)-(c), (iii)-(a)
View solution
Correct Option: A
Equity — long-term; Trade credit — short-term; Public deposits — medium-term.
Q 04 Lease Easy

A lease where substantially all risks and rewards of ownership are transferred to the lessee is called:

  • AOperating lease
  • BFinance lease
  • CWet lease
  • DSale-and-leaseback
View solution
Correct Option: B
**Finance / capital lease** transfers ownership risks and rewards to the lessee.
Q 05 Ind AS 116 Medium

Under Ind AS 116 / IFRS 16, almost all leases (other than short-term and low-value) on the lessee's balance sheet:

  • AAre kept off-balance sheet
  • BAppear as right-of-use asset + lease liability
  • CAppear only as expense
  • DAre capitalised only at lease end
View solution
Correct Option: B
Ind AS 116 / IFRS 16 brings the lease onto the balance sheet as **right-of-use** asset and lease liability.
Q 06 Leveraged Hard

A **leveraged lease** involves:

  • ATwo parties — lessee and lessor
  • BThree parties — lessee, lessor and a lender to the lessor
  • CAircraft only
  • DGovernment as lessor
View solution
Correct Option: B
**Leveraged lease** — lessor borrows from a third-party lender to finance the asset.
Q 07 Sale-leaseback Medium

"A company sells its head office building to a financial institution and then takes it back on lease." This is:

  • AOperating lease
  • BFinance lease
  • CSale-and-leaseback
  • DHire-purchase
View solution
Correct Option: C
**Sale-and-leaseback** unlocks cash from an owned asset while retaining its use.
Q 08 Internal Medium

Which is an **internal** source of finance?

  • AEquity share issue
  • BDebenture issue
  • CRetained earnings
  • DBank loan
View solution
Correct Option: C
**Retained earnings** (and depreciation) are internal sources.
Q 09 CP Medium

Commercial paper in India is regulated by:

  • ASEBI
  • BRBI
  • CMCA
  • DIRDAI
View solution
Correct Option: B
**RBI** regulates commercial paper (CP) — short-term unsecured promissory notes by rated corporates.
Q 10 Debt advantage Medium

A key advantage of debt financing over equity is:

  • AVoting rights
  • BTax-deductibility of interest
  • CNo risk to the firm
  • DHigher return to investor
View solution
Correct Option: B
Interest is tax-deductible → debt creates a **tax shield**.
Q 11 ECB Hard

External Commercial Borrowings (ECBs) in India are regulated by:

  • ASEBI
  • BRBI under FEMA 1999
  • CMCA
  • DDGFT
View solution
Correct Option: B
**RBI under FEMA 1999** issues the ECB Master Direction.
Q 12 Preference Medium

A preference share that may be converted into equity at a later date is called:

  • ACumulative
  • BParticipating
  • CConvertible
  • DRedeemable
View solution
Correct Option: C
Convertible preference shares can be converted into equity.
Q 13 Lease vs HP Hard

A key difference between leasing and hire-purchase is that under hire-purchase:

  • AAsset never transfers to the user
  • BOwnership transfers to the hirer at the end after all instalments paid
  • CHirer earns interest
  • DNo deposit is required
View solution
Correct Option: B
In hire-purchase, **ownership transfers** after the last instalment; in a lease, the lessor retains ownership.
Q 14 FCCB Hard

A Foreign Currency Convertible Bond (FCCB) is:

  • AA pure equity instrument
  • BA foreign-currency debt convertible into the issuer's equity at the holder's option
  • CA government bond
  • DA short-term commercial paper
View solution
Correct Option: B
FCCB — foreign-currency debt with embedded equity conversion option.
Q 15 Trade credit Easy

Trade credit is a source of:

  • ALong-term capital
  • BMedium-term capital
  • CShort-term spontaneous credit from suppliers
  • DForeign currency credit
View solution
Correct Option: C
Trade credit = suppliers granting credit period — spontaneous, short-term.
Q 16 Factoring Medium

Factoring involves:

  • ASale of fixed assets
  • BSale of receivables (book debts) to a factor for upfront cash
  • CIssue of shares
  • DIssue of debentures
View solution
Correct Option: B
**Factoring** — sell receivables to a factor; converts credit sales into cash.
Q 17 Authors Medium

"Finance is that administrative area which has to do with management of money and money substitutes." This definition is by:

  • AHoward and Upton
  • BSolomon
  • CModigliani-Miller
  • DPandey
View solution
Correct Option: A
**Howard and Upton** — classic textbook definition.
Q 18 Owner v Borrowed Medium

Which is **not** typically a difference between owner's and borrowed funds?

  • APermanence
  • BTax-deductibility of returns paid to investors
  • CVoting rights
  • DCurrency denomination
View solution
Correct Option: D
Currency is not a structural difference — both equity and debt can be in any currency.
Q 19 Lease pros Medium

Which is **not** an advantage of lease financing?

  • A100 % financing
  • BNo upfront cash outflow
  • COwnership of asset
  • DTax-deductible rentals
View solution
Correct Option: C
Lessee does *not* gain ownership; lessor retains it.
Q 20 Lease type Hard

In airline industry, a lease in which the lessor provides the aircraft along with crew, maintenance and insurance is called:

  • ADry lease
  • BWet lease
  • CSale-and-leaseback
  • DDirect lease
View solution
Correct Option: B
**Wet lease** = aircraft + crew + maintenance + insurance; **dry lease** = aircraft only.

28.10 Quick Recall

ImportantQuick recall
  • Finance function — three classical decisions: Investment, Financing, Dividend; modern fourth: Liquidity / WC.
  • Normative goal — shareholder wealth maximisation; vs profit maximisation (vague, ignores risk and time).
  • Long-term sources: equity, preference, debentures, term loans, retained earnings, ECB, FCCB, GDR/ADR, VC/PE.
  • Medium-term: term loans, lease, hire-purchase, public deposits.
  • Short-term: trade credit, bank credit, commercial paper, certificate of deposit, factoring, forfaiting, accruals, ICDs.
  • Lease types: operating, finance (capital), sale-and-leaseback, leveraged, direct, wet/dry.
  • Ind AS 116 / IFRS 16 — all leases on lessee balance sheet as right-of-use asset + lease liability.
  • Owner vs borrowed: residual vs fixed claim; perpetual vs limited; risk to firm low vs high; tax-shield on interest only.
  • Indian regulators: SEBI (public issues, ICDR), RBI (ECB/FCCB/NBFC, CP), MCA (Companies Act), FEMA (forex).