Explain how a large manufacturing business could finance investment in new machinery.
CAMBRIDGE
A level and AS level
Year Examined
October/November 2018
Topic
Finance
👑Complete Model Essay
Financing Investment in New Machinery for Large Manufacturing Businesses
Large manufacturing businesses often require significant capital investment for new machinery to remain competitive and meet evolving market demands. This essay will explore various financing options available to such businesses, considering both internal and external sources, while acknowledging the influence of the business's current financial standing on these options.
Internal Sources of Finance
Internal financing, derived from within the business, can be a cost-effective way to fund new machinery.
Retained Earnings
Retained earnings represent past profits reinvested into the business. A business with a history of strong profitability and a healthy cash flow may have accumulated sufficient retained earnings to finance a significant portion, if not all, of the investment. However, using substantial retained earnings for capital investment could limit future dividend payments to shareholders, potentially impacting investor confidence.
Asset Sales
Selling existing assets, especially if they are outdated or underutilized, can generate funds for new machinery. For example, a manufacturing business could sell older machinery or unused warehouse space. However, finding buyers and navigating the legal and logistical aspects of asset disposal can be time-consuming and may not realize the desired capital immediately.
External Sources of Finance
When internal sources prove insufficient, businesses turn to external financing options, each with its own advantages and disadvantages.
Equity Finance
For large manufacturing businesses structured as public limited companies (PLCs), issuing new shares of stock can raise substantial capital. This equity finance method, however, dilutes the ownership of existing shareholders and also subjects the company to increased market scrutiny and potential investor pressure.
Bank Loans
Bank loans are a common external financing option, offering large sums with structured repayment plans. However, they come with interest expenses, adding to the overall cost of the investment. Additionally, banks usually require collateral, potentially putting existing business assets at risk if loan repayments are not met. Example: A business might secure a $5 million loan from a bank to purchase a new assembly line, with the loan repaid over 10 years at a specific interest rate.
Government Grants
Depending on the industry and nature of the investment, manufacturing businesses might be eligible for government grants. These grants, typically aimed at promoting economic growth or technological advancement, do not require repayment, making them an attractive financing option. However, securing government grants is often competitive and subject to stringent eligibility criteria and reporting requirements.
Hire Purchase and Leasing
Instead of purchasing machinery outright, businesses can opt for hire purchase or leasing. Hire purchase involves gradual payments for the machinery, with ownership transferring to the business at the end of the agreement. Leasing, on the other hand, allows the business to use the machinery for a defined period by making regular lease payments, with ownership remaining with the leasing company. Both options reduce upfront costs but ultimately prove more expensive than outright purchase.
Conclusion
Choosing the optimal financing method for new machinery requires a thorough assessment of the business's financial position, the amount of capital required, and the associated costs and risks of each option. While internal sources like retained earnings and asset sales offer initial cost savings, they may not suffice for significant investments. External sources like equity finance, bank loans, government grants, and hire purchase/leasing provide alternative avenues, each with its own set of considerations. Ultimately, a strategic combination of financing options tailored to the specific circumstances of the business will likely yield the most favorable outcome.
Sources
The content of this essay draws upon general knowledge of business financing principles and does not cite specific academic texts.
Explain how a large manufacturing business could finance investment in new machinery.
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A-Level Business Studies Essay: Financing Investment in New Machinery
This essay guide will help you explore how a large manufacturing business can finance investment in new machinery. We'll consider various internal and external financing options, their advantages and disadvantages, and the factors influencing the best approach.
Understanding the Context
Before diving into specific financing methods, it's crucial to understand the context.
Key Considerations:
- Scale of Investment: The essay suggests a significant capital outlay. This impacts the feasibility of certain financing options.
- Existing Financial Position: The business's financial health influences its options. Does it have substantial retained earnings? Are there assets available for sale?
- Business Structure: Is the business a public limited company (plc)? This opens up avenues for equity finance.
Internal Sources of Finance
Internal sources are funds generated within the business. While they can be useful, they may not be sufficient for large investments.
Potential Internal Sources:
- Retained Profits: Profits not distributed as dividends can be reinvested.
- Sale of Assets: Selling surplus or obsolete assets can free up capital.
Advantages:
- No external debt: Lessens financial risk and interest payments.
- Control: No outside stakeholders influencing business decisions.
Disadvantages:
- Limited Availability: May not be enough for substantial investments.
- Opportunity Cost: Using retained profits for investment means sacrificing potential dividends for shareholders.
External Sources of Finance
When internal sources are insufficient, businesses turn to external finance. Here are some options:
Equity Finance (for plcs)
What It Is: Issuing new shares to raise capital. This dilutes existing shareholders' ownership.
Advantages:
- No repayment obligation: Unlike debt, equity does not require principal repayment.
- Can raise significant capital: Suitable for large investments.
Disadvantages:
- Loss of control: New shareholders have voting rights.
- Complex and costly: Legal and regulatory requirements can be significant.
Bank Loans
What It Is: Obtaining funds from a bank, repaid over a period with interest.
Advantages:
- Flexibility: Various types of loans available to suit different needs.
- Easier access than equity: May be more readily available for established businesses.
Disadvantages:
- Interest payments: Add to the cost of investment.
- Repayment obligation: Failure to repay can lead to financial distress.
Government Grants
What It Is: Financial assistance from government agencies, often aimed at supporting specific sectors or technologies.
Advantages:
- Free money: Grants do not need to be repaid.
- Can significantly reduce investment costs: Makes projects more feasible.
Disadvantages:
- Strict eligibility criteria: Not all businesses qualify.
- Limited availability: Competition for grants can be fierce.
Hire Purchase/Leasing
What It Is: Paying for the asset in installments while using it. Ownership passes to the business at the end of the agreement (hire purchase) or remains with the lessor (leasing).
Advantages:
- Lower upfront cost: Makes large investments more accessible.
- Tax benefits: Leasing payments are often tax-deductible.
Disadvantages:
- Higher total cost: Pay more over the life of the agreement compared to outright purchase.
- Potential for penalties: Late payments can result in fees.
Choosing the Right Financing Method
The optimal financing approach depends on various factors:
- The size of the investment: Large investments may require a mix of internal and external finance.
- Business's financial position: A strong balance sheet opens up more options.
- Risk tolerance: Equity finance carries more risk than bank loans, but it also offers greater potential returns.
- Government incentives: Grants can make investment more attractive.
Conclusion
Financing investment in new machinery is a critical decision for large manufacturing businesses. By carefully considering internal sources, various external options, and the associated advantages and disadvantages, businesses can select the most suitable financing approach to support their growth and competitiveness. Remember to analyze the context, the scale of investment, and the specific financial circumstances of the business to make an informed decision.
Extracts from Mark Schemes
How a Large Manufacturing Business Could Finance Investment in New Machinery
Answers could include:
• The context suggests a significant amount of capital investment.
• It depends on the assumptions made about the existing financial position of the business – has it significant retained earnings? – has it assets to sell?
• Internal sources may be limited and insufficient to finance all the expenditure required.
• Externally the following might be sources of finance:
- Equity finance if a plc.
- Bank loans.
- Government grants.
- Hire purchase/leasing.