IB Business Management SL 3.2 Sources of Finance Questions

Compare internal and external sources of finance and choose funding that fits a business purpose, cost, risk and time horizon.

Exam points

Define and identify the key concepts and tools in 3.2 Sources of finance.
Apply 3.2 Sources of finance to business calculations, case evidence or management decisions where relevant.
Analyse and evaluate 3.2 Sources of finance using case context, stakeholder impacts and business trade-offs.

Covered syllabus points

3.2.1—Internal sources of finance 3.2.2—External sources of finance 3.2.3—Short-term and long-term finance

[Maximum number: 6]

ELE encourages internal recruitment and promotion when management vacancies arise, seeking employees with ambition, initiative and a belief in change. Internal recruitment can motivate staff, retain organizational knowledge and reduce recruitment risk and cost, but it may limit new ideas and the pool of candidates. ELE originally financed its Zeat takeover with €49 million from internal sources. Suitable internal finance includes retained profit and the sale of surplus assets, although ELE must consider whether enough retained profit exists, the effect on dividends and whether any assets can be sold without harming operations. Retained profits also financed the gasoline-station store refurbishment.

Explain suitable internal sources of finance that ELE could have used to take over Zeat PLC.

[Maximum number: 2]

Justin Price Clothing Ltd. (JP) is a private limited company that manufactures clothing. Its unique selling point/proposition (USP) is its innovative process. Customers sends images of themselves and some measurements to JP via the internet, which JP uses to determine the customer’s exact measurements. Then, a style consultant contacts the customer via video conference to discuss the customer’s fashion preferences. After this, the style consultant designs clothing for that customer. Using job/customized production, JP manufactures and ships the clothing to the customer. Most materials (stock) are ordered when a customer agrees to the designs. A total of 84 % of JP’s customers have purchased items from JP more than five times.

Justin Price Clothing Ltd. (JP) is a private limited company that manufactures clothing.

Justin Price, JP’s owner, asked his management team to consider two options and decide which would best increase profitability:

Justin Price Clothing Ltd. (JP)

Justin Price Clothing Ltd. (JP) is a private limited company that manufactures clothing. Its unique selling point/proposition (USP) is its innovative process. Customers send images of themselves and some measurements to JP via the internet, which JP uses to determine the customer's exact measurements. Then, a style consultant contacts the customer via video conference to discuss the customer's fashion preferences. After this, the style consultant designs clothing for that customer. Using job/customized production, JP manufactures and ships the clothing to the customer. Most materials (stock) are ordered when a customer agrees to the designs. A total of 84 % of JP's customers have purchased items from JP more than five times.

Table 3: Selected financial information for the year or at year's end 2020, 2021 and 2022

Justin Price, JP's owner, asked his management team to consider two options and decide which would best increase profitability:
- Option 1: Change JP's design and production model. Consultants, when working with customers online, would recommend from a series of pre-made options. The company would shift to batch production and have the stock (inventory) available. Style consultants would still be central to the process, but the clothing would no longer be custom made.
- Option 2: Increase JP's customer base. JP's customers have high brand loyalty. However, the brand is not very well known. JP would open several strategically located retail stores in a few major cities to increase brand awareness. In the store, customers could get their measurements taken and receive in-person fashion advice from a fashion consultant, after which they could purchase unique clothing. JP would continue its online services.

State two features of loan capital.

[Maximum number: 10]

Frez PLC (FR) has 6000 employees in its 100 supermarkets and 250 in its head office. FR operates a 360-degree feedback appraisal system for head office employees. FR’s directors believe that this system has improved retention and morale of head office employees. This year, to reduce head office costs, FR offered head office employees the option of teleworking, which 60 % accepted. They will work at the head office only one day per month.

Frez PLC (FR)

Frez PLC (FR) has 6000 employees in its 100 supermarkets and 250 in its head office. FR operates a 360-degree feedback appraisal system for head office employees. FR's directors believe that this system has improved retention and morale of head office employees. This year, to reduce head office costs, FR offered head office employees the option of teleworking, which 60 % accepted. They will work at the head office only one day per month.
Each FR supermarket has 10 departments. Departmental managers have concerns about their workload caused by their large span of control. Labour turnover at FR supermarkets is increasing each year because departmental managers are leaving. In January, FR increased its supermarket opening hours and hired an additional 1000 part-time employees. FR is considering extending its 360-degree feedback appraisal system to all supermarket employees.
Recently, demand from supermarket shoppers for a home delivery service increased, although industry experts disagree on whether this demand will continue. FR's main competitors already provide delivery services.
FR has decided to launch a home delivery service. It will require 500 vans, which would be replaced every five years. FR is considering two options:
- Option 1: purchase the vans at a unit cost of $\$34000$ each, financed by a five-year bank loan at 3 % interest.
- Option 2: Lease the vans at a unit cost of $\$13000$ per year per van. The minimum term for the lease will be 24 months.
FR already borrowed $50 million in 2019 to finance the modernization of its supermarkets.

Recommend whether FR should choose Option 1 or Option 2.

There is no "correct answer". Answers could include:

Option 1

Pros

This option is less expensive in the long-term. The business will need to raise $\$ 17 \mathrm{~m}(500 \times \$\$34000$ )$. Currently interest rates are very low and therefore the interest charges will only raise the business costs by a relatively small amount. E.g. 3 % per annum ($510000 in year 1).

At the end of the five-year period the business intends to replace the vans - as it owns them it can sell them to raise some finance towards their replacement.

As FR already has a $\$ 50 \mathrm{~m}$ bank loan it might be assumed they have a good relationship with their bank and further borrowing would not be a problem.

Cons

The business will need to negotiate an additional loan from its bank and may need to provide the bank with additional financial documents and possibly collateral. Should the business fail to repay the loan then the collateral would be seized by the bank.

It is not a cost-free option even when interest rates are low, as a $\$ 17 \mathrm{~m}$ loan would incur interest charges of 3 % per annum ($510000 in year 1). If using simple interest this totals $\$ 19.55 \mathrm{~m}$ over five years.

If the trend to buying online is not maintained and shoppers gradually return to shopping face-to-face, then FR may have a large number of vans that it no longer needs but is paying for over five years. Whilst these could be re-sold there would be a significant loss made as second-hand prices will be a lot lower than the $\$34000$ purchase price.

FR would be liable for the maintenance and repair of vans.

Option 2

Pros

Leasing is more flexible. The business will need to lease the vans for at least 24 months. At that point if it finds that consumer trends have changed then it can either not renew the leases on 500 vans or lease a much smaller number, say 200 . This will save the business money in the long run e.g. leasing just 200 vans will cost only $\$ 2.6 \mathrm{~m}$ per year.

If after 24 months demand is not seen to be there then the business could end the lease and purchase vans, saving money in the long run.

One of the tax advantages to leasing a van could include claiming up to 100 % sales tax back on the monthly payments. Also, leasing payments are expenses and, thus, lower pre-tax profits and income tax expense.

In addition, lessors are usually liable for maintenance and servicing of the vans on a regular basis.
N.B. Terms and conditions of fleet leasing vary. In some instances, lessors are not responsible for maintenance or service. In other cases, fleet lessors are responsible for service and maintenance, though they often contract out the management of the service and maintenance to a third company for a monthly fee.

Given the limited experience of our candidates, which could well inform their knowledge about vehicle leases, candidates can argue that FR will not be responsible for maintenance and servicing (a pro of leasing) or that FR might still be responsible for maintenance and servicing (a con of leasing).

Cons

This may have higher long-term costs. A lease of 500 vans will cost the business $\$ 6.5 \mathrm{~m}$ annually ( $500 \times \$ 13000$ ). Over five years this would be $\$ 32.5 \mathrm{~m}$ which is almost twice the cost of the option A. This is a significant difference in terms of costs.

At the end of each lease period the business does not own the vans and has to negotiate a new leasing agreement.

The business will pay penalties at the end of the lease agreement if the leased vans are damaged in any way.

Maximum mark award

Option 1

Option 2

Judgments/conclusion

3

One argument related to only one option.

N/A4

One argument for and one argument against either of the two options. OR One argument related to Option 1 and one argument related to Option 2.

N/A5

One argument for and one argument against one option and one argument for or against the other option.

N/A6

At least one argument for and one argument against both options.

No judgments/conclusions

7-8

Balanced arguments for both options.

Judgments/conclusions based upon analysis and explanation in the body of the response

Relevant business management tools (where applicable), techniques and theories are explained and applied well, and appropriate terminology is used.

Good reference to the stimulus material.

9-10

Balanced arguments for both options.

Judgments/conclusions based upon analysis and explanation in the body of the response.

Relevant business management tools (where applicable), techniques and theories are explained clearly and applied purposefully, and appropriate terminology is used throughout the response.

Effective use of the stimulus material in a way that significantly strengthens the response.

It is expected that candidates provide a conclusion with a substantiated judgment.

Marks should be allocated according to the markbands on page 3.

If a candidate evaluates / addresses only one option, award a maximum of [5].

A balanced response is one that provides at least one argument for and one argument against each option.

Candidates may contrast one option with another for a balance as long as at least two arguments are given for each option.

Award a maximum of [6] if the answer is of a standard that shows balanced analysis and understanding throughout the response with reference to the stimulus material but there is no judgment/conclusion.

Candidates cannot reach the [7-8] markband if they give judgment/conclusions that are not based on analysis/explanation already given in the answer.

All question bank results loaded

Covered syllabus points

Question 1

Question 2

Question 3