Amity School Of Business Sources of Long Term Finance Module-1

Amity School Of Business

Module-1


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Sources of Finance

Debt EquityHybrid

instrumentsAsset

Based Financing

TermLoans

DebenturesEquity Shares

ADR’sGDR’s

Preference Shares

Convertible Securities

Warrants

Leasing

Hire-Purchase

Installment

Factoring/Forfaiting

Internal Accruals

FRN’s, FCCB


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• Pre – emptive rights: Entitles a shareholder to maintain his proportionate share of ownership

Rights issue: New ordinary shares must be first issued to the existing shareholders on a pro rata basis

Involves less cost

Subscription price set much below the current market price

Shareholders who fail to exercise their rights dilute their ownership

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Merits Demerits

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• A hybrid security – it has features of both ordinary shares and debentures

Features• Prior claims on income and assets over ordinary shares• Fixed Dividend: Expressed as a percentage of par value• Redemption: Redeemable or perpetual preference

shares can be issued

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• Cumulative dividends: All past unpaid preference dividend will be paid before ordinary dividends are paid

• Call Feature: Permits the company to buy back at a stipulated buy – back or call price

• Participation: May participate in extra ordinary profit earned by the company

• Voting Rights: Contingent or conditional

• Convertibility: Can be converted fully/partially into ordinary shares

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Amity School Of BusinessDebentures

• A long term promissory note for raising loan capital

• Debentures holders are the creditors of the firm

Features• Interest rate: Fixed; called contractual rate of interest

• Interest is tax deductible

• Maturity: Specific period of time

• Claims on assets and income: Claim on company’s earnings prior to that of shareholders

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Features of Debentures

• Redemption: can be done through Sinking fund: cash set aside periodically for retiring

debentures Buy back Provision: Redeem debentures at a specified

price before the maturity date

• Indenture/Debenture trust deed: A legal agreement between the company and debenture trustees

• Security: Can be secured by a lien on company’s assets; Unsecured debentures not protected by security

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Yield of a Debenture

Current Yield: Ratio of the annual interest payment to debenture’s market price E.g. The current yield of a 14 percent Rs. 1000 debenture currently selling at Rs. 750 is

Annual Interest/ Market Price

= 140/750 =0.187 % or 18.7 %Yield to maturity: Takes into account

payments of interest and principal over the life of a debenture; IRR of debenture

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Types of Debentures• Non – Convertible debentures: Pure debentures, no

conversion

• Zero – interest/ Deep discount debentures: Issued at a

highly discounted price.

• Fully convertible debentures: Convertible into shares as per the terms of the issue

• Partially convertible debentures: Has two parts: convertible and non - convertible

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Merits of Debentures• Less costly: Investors require lesser ROR; interest

payments are tax deductible

• No ownership dilution

• Fixed payment of interest

• Reduced real obligation: Obligation of paying fixed interest and principal declines in real terms during inflation

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Demerits of Debentures• Obligatory payments

• Financial Risk: Increases firm’s leverage

• Cash outflows: Must be paid on maturity, involving huge cash outflows

• Restricted Covenants: Debenture indenture may limit company’s flexibility

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Amity School Of BusinessTerm Loans

• Term loans represent long – term debt

• Obtained from banks and other Financial Institutions (FIs)

• Purpose is mainly to finance capital expenditure

• Also called “Project Financing”

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Amity School Of BusinessFeatures

• Maturity: Generally for 6 – 10 years

• Security: Always securedThe assets acquired using term loans secure them –

primary security; The company’s present and future assets also

secure them – secondary/collateral securityLender may create “fixed charge” (legal mortgage on

specific assets) or “floating charge” (general mortgage on all assets)

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Features of Term Loans

• Direct Negotiation: Private Placement; low cost of raising loan

• Restrictive covenantsAsset related: Minimum asset base to be

maintained; minimum working capital, restriction on creation of further charge on assets

Liability related: Restrains in taking additional debt; reduce its debt/equity

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• Convertibility: Options of converting loans into equity

• Repayment Schedule/ loan amortization: Time schedule for payment of interest and principal

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Balloon payments: Repayment of principal in annual/semi-annual installments and payment of interest on the unpaid amount

Capital Recovery: Payment of equal loan installments including both interest and principal payments

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Internal Accruals/ Retained Earnings

• Consists of Retained Earnings and Depreciation

Merits • Readily available internally

• Represent infusion of additional equity without extra cost

• No Dilution of control

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Amity School Of BusinessDemerits

• Only limited amount can be raised

• High opportunity cost

• Easy availability may lead to investment in sub – optimal projects

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Lease Financing

Financial or Capital Lease• It is an intermediate term to long term non cancelable

arrangement. There is a primary lease period.• The lessee is responsible for maintenance insurance and

taxes but cannot claim depreciation.• The lessee usually enjoys the option for renewing the

lease for substantially reduced lease rentals.

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Lease Financing• Operating Lease

• The lease term is significantly less than the economic life of the equipment

• The lessee enjoys the right to terminate the lease at short notice without any penalty

• Operating know how, insurance and maintenance is provided by lessor

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Amity School Of BusinessHIRE PURCHASE

• The Hiree purchases the asset and gives it on hire to the hirer

• The hirer pays regular hire purchase installment over a specified period of time. At the end of the last installment the title is transferred from the hiree to the hirer Hirer can claim depreciation.

• Interest is charged on a flat basis

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Amity School Of BusinessInstallment

• Installment sale is a credit sale and the legal ownership of the asset passes immediately to the buyer as soon as the agreement is made between the buyer and the seller

• The outstanding installments are treated as secured loan

• As the owner of the asset, the buyer is entitled to depreciation and interest as deductible expenses

• Except for the timing of the transfer of ownership, installment sale & Hire Purchase are similar in nature

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Amity School Of BusinessFACTORING

• A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales

Features of a Factoring Arrangement• The factor selects the accounts of the client that would

be handled by it, and along with the client, the credit limits applicable

• The factor assumes responsibility for collecting the debt of accounts handled by it

• The factor advances money to the client against not yet collected and not yet due debts

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Amity School Of BusinessFactoring

• Factoring can be on a recourse basis (credit risk is borne by the client) and non recourse basis (credit risk is borne by the factor

• Besides the interest on advances against debt, the factor charges a commission which may be 1 - 2% of the face value of debt factored.

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Amity School Of BusinessForfaiting

• Forfaiting means selling a bill of exchange at a discount, to a third party the forfaiter, who collects the payment from an overseas customer, assuming the underlying responsibility of exporters and simultaneously providing trade finance for importers by converting a short-term loan to a medium term one

• Approved by the Reserve Bank of India since1992

• Apart from EXIM Bank, all Authorized Dealers can act as intermediaries between the Indian exporter and the overseas Forfaiting agency

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Amity School Of BusinessForfaiting

• Characteristics:

– Credit is extended by the exporter for period ranging between 180 days to 7 years.

– Minimum bill size should be US$ 250,000/-.( US$ 500,000/- is preferred)

– The payment should be receivable in any major convertible currency.

– A guarantee by a bank, usually in importer's country.

– The contract can be for either goods or services.

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Amity School Of BusinessADR

• A negotiable certificate issued by a U.S. bank representing a specific number of shares of a foreign stock traded on a U.S. stock exchange

• They are bought and sold in the American markets just like regular stocks

• ADRs are generally listed on the NYSE, AMEX, or Nasdaq. However, some ADRs are not listed on an exchange, but trade on the Over-the-Counter (OTC) market

• The companies that issue ADRs are registered and regulated by the U. S Securities & Exchange Commission (SEC)

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Amity School Of BusinessGDR

• Global Depository Receipt (GDR) : A certificate issued by international bank, which can be subject of worldwide circulation on capital markets

• GDR's are emitted by banks, which purchase shares of foreign companies and deposit it on the accounts

• Global Depository Receipt facilitates trade of shares, especially those from emerging markets. Prices of GDR's are often close to values of related shares

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Amity School Of BusinessIDR

• IDR means any instrument in the form of depository receipt created by the domestic depository in India against the underlying equity shares of the issuing company

• This has been stipulated in the Companies (Issue of Indian Depository Receipts) Rules, 2004

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Floating Rate Notes (FRN’s)• FRNs are medium- to long-term debt obligations with variable

interest rates that are adjusted periodically (typically every one, three, or six months). The interest rate is usually fixed at a specified spread over one of the following specified deposit rates:

- London interbank offered rate (LIBOR),- London interbank bid rate (LIBID), or- London interbank mean rate (LIMEAN) (average of LIBOR and LIBID).

• FRNs may also use short-term obligations of the U.S. government (Treasury bills) to establish their interest rate. Interest is payable at the end of each interest period.

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Foreign Currency Convertible Bond - FCCB• A type of convertible bond issued in a currency different

than the issuer's domestic currency.

• In other words, the money being raised by the issuing company is in the form of a foreign currency

• A convertible bond is a mix between a debt and equity instrument

• It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock

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Amity School Of BusinessWarrants

• A warrant entitles the purchaser to buy a fixed number of ordinary shares at a particular price during a specified period

• Warrants are generally issued along with debentures as “sweeteners” (to improve the marketability of the issue)

• May also be used in conjunction with ordinary or preference shares

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Amity School Of BusinessWarrants

• Exercise Price of a warrant is the price at which its holder can purchase the issuing firm’s ordinary shares

• Exercise ratio states the number of ordinary shares that can be purchased at the exercise price per warrant

• Expiration date is the date when the option to buy ordinary shares in exchange rate for warrant expire

• A warrant can be sold separately from the security to which it was originally attached

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Convertible Debentures• A convertible debenture is a debenture that can

be changed into a specified number of ordinary shares at the option of the owner

• The most notable feature of this debenture is that it promises a fixed income associated with debenture as well as chance of capital gains associated with equity share after the owner has exercised his conversion option

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Amity School Of Business Sources of Long Term Finance Module-1