Credit terms 4/15, net 35 mean:

• 4% cash discount if payment is made within 15 days
• Otherwise, full payment is due within 35 days

So, if the discount is not taken, the firm gets extra credit for:

$35-15=20 \text{ days}$

Cost of not taking the discount per period:

$\frac{d}{100-d}=\frac{4}{96}=0.0416667=4.1667\%$

1. Annual Percentage Cost (APC)

$\text{APC}=\frac{d}{100-d}\times \frac{365}{N-D}$

$=\frac{4}{96}\times \frac{365}{20}$

$=0.0416667\times 18.25$

$=0.7604167$

$\boxed{\text{APC}=76.04\% \text{ p.a.}}$

2. Effective Annual Rate (EAR)

$\text{EAR}=\left[1+\frac{d}{100-d}\right]^{\frac{365}{N-D}}-1$

$=\left[1+\frac{4}{96}\right]^{18.25}-1$

$=(1.0416667)^{18.25}-1$

$=2.1064444-1$

$=1.1064444$

$\boxed{\text{EAR}=110.64\% \text{ p.a.}}$

Answer:
Annual percentage cost = 76.04%
Effective annual rate = 110.64%

(If a 360-day year is used, APC = 75% and EAR = 108.51%.)

Total debt = Rs 700,000 Long-term debt = 30% of 700,000 = Rs 210,000 Short-term debt = 700,000 − 210,000 = Rs 490,000

A short-term source of debt is a source of borrowed funds that is typically repaid within one year or within the operating cycle, whichever is longer. Examples include bank overdraft, trade credit, and commercial paper.

Total debt = $\dfrac{8,00,000}{80\%} = \text{Rs. } 10,00,000$

Short-term debt = Total debt − Long-term debt
= Rs. 10,00,000 − Rs. 8,00,000
= Rs. 2,00,000

Given: Terms 3/10, net 50; discount $d = 3\%$; extra credit period if the discount is forgone = 50 − 10 = 40 days; year = 365 days.

Annual percentage cost (APC)

$\text{APC} = \frac{d}{100-d} \times \frac{365}{N-D} = \frac{3}{97} \times \frac{365}{40} = 0.030928 \times 9.125 = 0.2822 = 28.22\%$

Effective annual rate (EAR)

$\text{EAR} = \left(1 + \frac{3}{97}\right)^{\frac{365}{40}} - 1 = (1.030928)^{9.125} - 1 = 0.3204 = 32.04\%$

Answer: Annual percentage cost = 28.22%; effective annual rate = 32.04%.

Two advantages of short-term debt for a company:

1. Lower cost — short-term debt usually carries a lower interest rate than long-term debt, so the company pays less for the funds.
2. Flexibility — it can be raised quickly and repaid as soon as the need is over, avoiding a long-term commitment of fixed interest payments.

Short term source = 40% of total debt capital = Rs 3,00,000

$\text{Total debt capital} = \frac{3,00,000}{40} \times 100 = \text{Rs } 7,50,000$

Total debt of the company = Rs 7,50,000.

Fixed rate of dividend and priority in payment of dividend and repayment of capital.

Preferred stock (preference shares) carries a fixed rate of dividend and gives holders priority over equity shareholders both in the payment of dividend and in the repayment of capital at the time of winding up.

Meaning of Preference Share

A preference share is a type of share that carries a preferential right over equity (ordinary) shares in two matters: (i) payment of dividend at a fixed rate before any dividend is paid to equity shareholders, and (ii) repayment of capital on the winding up of the company before equity shareholders are paid. Since preference shareholders enjoy these preferential rights but normally do not participate in the control and management of the company, preference shares are also called hybrid securities, as they combine features of both shares (ownership) and debentures (fixed return).

Features of Preference Shares

1. Fixed rate of dividend: Preference shareholders receive dividend at a fixed rate (e.g., 10%) on the face value of shares. The rate is mentioned in the share certificate, so their income is certain, like interest on debentures.

2. Preferential right over dividend: Dividend is paid to preference shareholders before it is paid to equity shareholders. If profits are insufficient, equity shareholders may get nothing, but preference shareholders are paid first (in case of cumulative preference shares, arrears are carried forward).

3. Preferential right on repayment of capital: At the time of winding up, the capital contributed by preference shareholders is returned before the capital of equity shareholders.

4. Limited voting rights: Preference shareholders generally do not have voting rights in the general meetings of the company. They can vote only on matters directly affecting their rights, or when their dividend remains unpaid for a specified period (two years or more in the case of cumulative preference shares).

5. No participation in management: Since they have no normal voting rights, preference shareholders have no voice in the management and control of the company. Control remains with equity shareholders.

6. Redeemable in nature: Preference shares are generally redeemable after a certain period as per the terms of issue. A company can issue redeemable preference shares subject to the provisions of the Companies Act.

7. Cumulative or non-cumulative: In the case of cumulative preference shares, unpaid dividend is accumulated and paid in later years before any dividend is paid to equity shareholders. In non-cumulative preference shares, the dividend does not accumulate if profits are insufficient in a year.

8. Convertible or non-convertible: Convertible preference shares can be converted into equity shares after a specified period, while non-convertible preference shares cannot be so converted.

9. Participating or non-participating: Participating preference shares give the holders a share in surplus profits or surplus assets after equity shareholders receive a certain minimum. Non-participating preference shares carry only the fixed rate of dividend.

10. Source of long-term finance: Preference shares provide long-term finance to the company without diluting the control of existing equity shareholders, and the dividend paid on them is a charge against profits.

Conclusion

Preference shares thus give investors a safe and fixed return with priority in dividend and capital repayment, while allowing the company to raise long-term funds without losing control. However, the fixed dividend is a burden on profits and the cost of such capital is generally higher than that of debt because dividend is not tax-deductible.

Common stockholders are the residual owners of the company and receive dividends only after preferred stockholders are paid, while preferred stockholders have a prior claim on dividends and on assets at liquidation.

Two criteria of difference:

1. Claim on income (dividend): Preferred stockholders get a fixed rate of dividend before any dividend is paid to common stockholders; common stockholders get dividends only out of the remaining profit, which varies with earnings.
2. Claim on assets at liquidation: At the time of liquidation, preferred stockholders have a prior claim on the assets of the company over common stockholders, who are paid only after all other claims are settled.

Sources of Fund Based on Time and Ownership

Sources of fund refer to the various ways through which a business raises the money it needs to finance its assets and operations. They are classified on two bases: time and ownership.

A. On the Basis of Time

1. Long-term sources Funds required for more than five years, used to buy fixed assets like land, building, plant and machinery. These include:

• Equity shares
• Preference shares
• Debentures
• Long-term loans from banks and financial institutions
• Retained earnings

2. Medium-term sources Funds required for more than one year but up to five years, used for modernization, renovation and expansion. These include:

• Term loans from banks
• Lease financing
• Public deposits
• Venture capital

3. Short-term sources Funds required for one year or less, used to meet working capital needs such as purchase of raw materials and payment of wages. These include:

• Bank overdraft
• Cash credit
• Trade credit
• Bills of exchange
• Commercial paper
• Factoring

B. On the Basis of Ownership

1. Owned funds (owners' capital) Funds contributed by the owners themselves and which need not be repaid. They carry the risk of the business. These include:

• Equity share capital
• Preference share capital
• Retained earnings
• Reserves and surplus

2. Borrowed funds Funds raised through loans and credit from outsiders, which must be repaid with interest. These include:

• Debentures
• Bank loans
• Public deposits
• Trade credit
• Bonds

Conclusion

A business must strike a proper balance between long-term, medium-term and short-term sources, and between owned and borrowed funds, so that it earns enough to pay interest and still leave a satisfactory return for the owners.

Terms 4/10 net 18 mean a 4% discount if paid within 10 days; otherwise the full amount is due on day 18. Purchase = Rs 5,00,000, so the discount is Rs 20,000 and the net amount if discount is taken is Rs 4,80,000.

(a) Annual cost of debt

Credit period gained by skipping the discount = $18 - 10 = 8$ days.

$\text{Cost} = \frac{\text{Discount \%}}{100 - \text{Discount \%}} \times \frac{360}{\text{Credit period} - \text{Discount period}} = \frac{4}{96}\times\frac{360}{8} = 0.041667 \times 45 = 187.5\%$

(b) Effective rate

The cost of 4.1667% for each 8-day period is compounded $360/8 = 45$ times a year.

$\text{Effective rate} = \left(1+\frac{4}{96}\right)^{45} - 1 = (1.041667)^{45} - 1 \approx 5.2776 = 527.76\%$

(c) Payment stretched to 42 days

Extra credit period = $42 - 10 = 32$ days.

$\text{Cost} = \frac{4}{96}\times\frac{360}{32} = 0.041667\times 11.25 = 46.875\% \approx 46.88\%$

Stretching payment to 42 days cuts the annual cost from 187.5% to 46.88%, because the same 4.17% charge is spread over a longer period. Even so, the cost is far above normal bank interest, so the discount should be taken whenever the firm can arrange cash.