INTRODUCTION

No business activity can take place without finance or the means of purchasing the raw materials and assets needed before production of a good or provision of a service. Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset acquirement - new machinery or the construction of a new building or depot. The development of new products can be enormously costly and here again capital may be required. Normally, such developments are financed internally, whereas capital for the acquisition of machinery may come from external sources. In this day and age of tight liquidity, many organizations have to look for short term capital in the way of overdraft or loans in order to provide a cash flow cushion. Interest rates can vary from organization to organization and also according to purpose. What are the different sources of finance for a business? LONG TERM DEBT CAPITAL: Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company. Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. Debentures are often secured on a particular asset, which means the investors have the right, if the company ceases trading, to sell that particular asset to gain repayment. When this is part of the agreement, the debentures are known as mortgage debentures.

LEASING: A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time. Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and commercial vehicles, but might also be computers and office equipment. There are two basic forms of lease: "operating leases" and "finance leases". This agreement allows the firm to avoid cash purchase of the asset. The risk of unreliable or outdated is reduced as the leasing company will repair and update as part of the agreement. Leasing is not a cheap option, but they do improve the short term cash flow position of a company compared to outright purchase of an asset for cash.

BANKLENDING: Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days. Short term lending may be in the form of: a) An overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day; b) A short-term loan, for up to three years. Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate. Merchant banks are specialist lending institutions. They provide advice as well as finance to firms engaging in expansion or merger/takeover plans.

RETAINED EARNINGS: For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. If a company is trading profitably, some of these profits will be taken in tax by the government (corporation tax) and some is nearly always paid out to the owners or shareholders (Dividends). If any profit remains, this is kept (retained) in the business and becomes a source of finance for future activities.

COST OF FUND Cost of fund is defined as the interest rate paid by financial institutions for the funds that they deploy in their business. Cost of fund is the most important variable for any business. It is one of the most important input costs for a financial institution, since a lower cost will generate better returns when the funds are deployed in the form of short-term and long-term loans to borrowers. The spread between the cost of funds and the interest rate charged to borrowers represents one of the main sources of profit for most financial institutions.

EQUITY AS A SOURCE OF FUND EQUITY FINANCING: It is defined as the process of raising capital through the sale of shares in an enterprise. Equity Financing is not only the sale of common shares, but it also includes the sale of Preferred Shares and convertible Preferred Shares. A Startup business goes through various rounds of Equity Financing. For instance, Angel Investors and Venture Capitalists usually invest in a startup. In exchange, they prefer convertible preferred shares over common equity. This is because the former has an upside potential (i.e. higher yield, preference over common shares on payment of dividends and liquidation of assets) over the common shares. As the company grows large, it requires more Capital and material. Therefore they go public and distribute shares in mass to Retail Investors in a Stock Exchange Market. (Example: Bombay Stock Exchange) Investor appetite for Equity Financing depends significantly on the state of the Financial Markets and Equity Market in particular.

COST OF EQUITY DETERMINATION MODELS: 1.) CAPM (Capital Asset Pricing Model) 2.) DDM (Dividend Discount Model) or Gordons Model

CAPITAL ASSET PRICING MODEL: The CAPM as the name suggests, is a theory that explains how asset prices are formed in the market place. It provides the framework for determining the equilibrium expected return for risky assets. CAPM uses results of capital market to derive the relationship between expected return and systematic risk of individual assets and portfolios.

CAPM FORMULA

DIVIDEND DISCOUNT MODEL A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued. The ordinary/equity shareholders buy or hold shares in expectations of periodic cash dividends and an increasing share value. They would buy a share if it is undervalued (i.e. true value is more than its market price) and sell it when its overvalued (i.e. market value is more than its true value.

DIVIDEN DISCOUNT MODEL FORMULA

The variable k here also represents the cost of equity. g is the constant growth of dividends

ASSUMPTIONS OF DIVIDEND DISCOUNT MODEL: 1.) The firm is an all-equity firm. No external financing is used and investment programmes are financed exclusively by retained earnings. 2.) ke is constant. 3.) The firm has perpetual life. 4.) The retention ratio, once decided upon, is constant. Thus, the growth rate g is constant. 5.) ke > g 6.) The Dividend Discount Model considers Dividends as the only source of income.

DIFFERENT FORMS OF DIVIDENDS

Cash Dividend

Stock Dividend

Cash Dividends: A cash dividend is money paid to stockholders,

Stock Split Buy-Back

normally out of the corporation's current earnings or accumulated profits. Not all companies pay a dividend. Usually, the board of directors determines if a dividend is desirable for their particular company based upon various financial and economic factors. Dividends are commonly paid in the form of cash distributions to the shareholders on a monthly, quarterly or yearly basis. All dividends are taxable as income to the recipients.

Dividends are normally paid on a per-share basis. If you own 100 shares of the ABC Corporation, the 100 shares is your basis for dividend distribution. Assume for the moment that ABC Corporation was purchased at 100/share, which implies a 10,000 total investment. Profits at the ABC Corporation were unusually high so the board of directors agrees to pay its shareholder 10 per share annually in the form of a cash dividend. So, as an owner of ABC Corporation for a year, your continued investment in ABC Corp should give us 1,000 in dividend dollars.

Stock Dividends (Bonus Shares) and Stock Split: An integral part of dividend policy of a firm is the use of bonus shares and stock splits. Both involves issuing new shares on a pro rata basis to the current shareholders while the firms assets, its earning, the risk being assumed and the investors percentage ownership in the company remain unchanged. In laymans terms, Bonus Shares involve payment to existing owners of dividend in the form of shares. On the other hand, Stock Split is a method commonly used to lower the market price of shares by increasing the number of shares belonging to each shareholder.

Buyback of Shares (Share Repurchase): Buyback implies that a company buys back its own shares. It is an alternative method to pay cash dividends. Share repurchase reduces the number of equity shares outstanding in the market. Given no change in corporate earnings and the price-earnings ratio, share repurchases would result in higher Earnings Per Share (EPS) and market price of share.

LITERATURE REVIEW
Whether price movements in the stock market can be justified in terms of the simple efficient market model has long been debated, although there is no universally accepted definition of the term efficient market model. The conventional model has been the dividend discount model. Most financial economists believe that the DDM provides a good approximate description of stock price determination, at least, for the aggregate market. LeRoy and Porter (1981) and Shiller (1981) challenged this view by pointing out that aggregate stock prices appear to be too volatile to be measured by the fundamentals (i.e., dividends) in the DDM.

The dividend discount model attraction is its simplicity and its logic, however there are many analysts who view its results with some suspicion because of the limitations that they believe it possess. According to Damodaran (2002) some researcher claim that dividend discount model is not really useful in valuation, expect for a limited number of stable, high-dividend paying stocks. A standard critique of the dividend discount model is also that it provides a too conservative estimate of the value. This is based on the notion that the value is determined by more than the present value of expected dividends. It is argued by researchers that the DDM does not reflect the value of unutilized assets, however there is no reason that for these unutilized assets cannot be valued separately and added on the value from the dividend discount model. Some assets that are ignored by the DDM such as value of brand names can be dealt within the context of the model. (Damodaran, A 2002, p. 477) A more realistic criticism of the model is that it does not incorporate other ways of returning cash to stock-holders such as stock buybacks. However if one use the modified version of the dividend discount model this criticism can also be countered. There have been done tests on how well the dividend discount model works at identifying undervalued and overvalued stocks. A study of dividend discount model was conducted by Sorensen and Williamson (1980) where they valued 150 stocks from the S&P 500 using the dividend discount model. They used the difference between the market price at

that time and the model value to form five portfolios upon the degree of under or over valuation. They made fairly broad assumption in using the dividend discount model. 1. The average of the earnings per share between 1976 and 1980 was used as the cur-rent earnings per share. 2. The cost of equity was estimated using the CAPM 3. The extraordinary growth period was assumed to be five years for all stocks

4. The stable growth rate, after the extraordinary growth period, was assumed to be 8% for all stocks. 5. The pay-out ratio was assumed to be 45% for all stocks.

The returns on these five portfolios were estimated for the following two years (January 1981-January 1983) and excess returns were estimated relative to the S&P 500 Index using the betas estimated at the first stage and CAPM. The undervalued portfolio had a positive excess return of 16% per annum between 1981 and 1983, while the overvalued portfolio had a negative excess return of 15% per annum during the same time period. Other studies which focus only on dividend discount model come to similar conclusions. In the long term, undervalued (overvalued) stocks from the dividend discount model outperform (underperform) the market index on a risk adjusted basis. (Damodaran, A 2002, p. 47) It is clear from Sorensen and Williamson tests that the dividend discount model provides impressive results in the long term, there are however three important consideration in generalizing the findings from these studies. First one, is that the dividend discount model does not beat the market every year, there have been individual years where the model has significantly underperformed the market.