Long Term Funds

Chapter 12Chapter 12

SOURCES OF LONG-SOURCES OF LONG-TERM FINANCETERM FINANCE

Himalaya Publishing House

Financial Management: Principles and

Practice By G. Sudarsana Reddy

Chapter 12Sources of Long-Term Finance

LEARNING OBJECTIVESLEARNING OBJECTIVES• Classify the sources of finance• Financial Markets• Say the sources of long-term finance• Kinds of ownership securities and discuss the merits and demerits• Discuss the creditorship securities in brief• Say what is internal financing• Distinguish between equity shares and debentures• Say what is term loan, and give features of term loan• Discuss the sources of term loans• Discuss in detail each of the developmental financial institutions • Give the meaning for innovative source of finance leasing, hire purchasing,

project finance, venture capital, euro issues, and bridge finance.





Sources of Long-term FinanceSources of Long-term Finance

Sources of Long-term Funds

Owned Capital Debt Capital

Share Capital

Debentures

Retained EarningsInstitutional Loans

Equity Share Capital

Preference Share Capital

Debentures





Types of Security FinancingTypes of Security FinancingTypes of Security Financing

Ownership Securities Creditorship Securities

Equity Share Capital

Preference Share Capital

Debentures





Equity Shares

• A share that gives equal right to holders

Features:

•Permanent capital

•Residual claim on income

•Residual claim on assets

•Voting right/right to control

•Preemptive right

•Limited liability





Evaluation of Equity Stock

(a) Advantages / Merits to Company• It is permanent long-term source of finance• There is no repayment liability• It does not create any obligation to pay dividend • This capital can be issued without creating any charge over assets of

the company• Issue of equity share capital increases the credit worthiness of the

company.

(b) Advantages / Merits to Investors• Equity share provides more income (residual income)• Equity shares gives right to participate in the control and management

of the company• Capital appreciation (if share price increased when compared purchase

price).





Evaluation of Equity Stock (contd.)

(a) Disadvantages / Demerits to Company

• High cost source of fund

• Involves high flotation costs

• Issue of additional shares dilutes control

• No tax advantage (dividends are not tax deductible)

• It make capital structure rigid

(b) Disadvantages / Demerits to Investors

• No guarantee, regularity of receipt of dividend

• No guarantee of receipt of principle amount of investment

• Loss of capital due to fluctuations in share prices





Preference SharePreference Share

• Preference Stock: Stock that has preferential rights over equity shareholders

• Preference stock is also known as hybrid stock:

- A preferential privilege in payment of a fixed dividend

- Preferential right as to repayment of capital in case of

liquidation





Preference Stock Resembles Equity and Debt

Preference share resembles equity in the following ways:• Preference dividends are payable only after tax profits (PAT),• Payment of preference dividend depends on the discretion of BOD’s, (it is

not an obligatory payment),• Preference dividend is not a tax deductable payment,• Irredeemable preference shares are long-term in nature (they have no

maturity date). Preference share capital is similar to debenture capital in the following ways:

• It carries a fixed rate of dividend.• It has prior claim on assets like debenture capital,• It normally does not have voting rights,• It is redeemable in nature (if it is redeemable preference share),• It does not have right to share residual profits/ assets.





Features of Preference SharesFeatures of Preference Shares

• Claim on assets

• Claim on income

• Accumulation of dividend

• Redeemable

• Fixed rate of dividend

• Convertibility

• Participation in surplus profits

• Voting right (to protect their interest)




Chapter 12Sources of Long-Term FinanceEvaluation of Preference Stock

(a) Advantages / Merits to Company• There is no legal obligation to pay preference dividend• There is no share in control of the company through participation in

voting• They provide flexibility in capital structure by issue of redeemable

preference shares• It enhances credit worthiness, because preference share capital is

generally treated as a part of net worth• Preference shares provide long-term capital for the company• Mortgageable assets are conserved, due to the issue of preference share

capital without pledging assets. (b) Advantages / Merits to Investors

• Stable rate of preference dividend • Prior claim on assets• Less risk when compared to equity shareholders




Chapter 12Sources of Long-Term FinanceEvaluation of Preference Stock (contd.)

Disadvantages / Demerits of Preference Shares • The disadvantages of preference shares can be studied under two heads, they are

company and investors.(a) Disadvantages / Demerits to Company

• Tax disadvantage, because preference dividend is not a tax deductible, which make preference share capital as costly source of finance

• Adverse effect on creditworthiness, if the company avoids payment of dividend• Permanent burden of payment of dividends, if the preference shares are cumulative in

nature(b) Disadvantages / Demerits to Investors

• Limited return, as preference shareholders do not have voting rights, their return depends on managerial decision, which is arbitrary, and shareholders cannot force management to pay more dividends.

• The rate of preference dividend is generally less than the rate of dividend on equity shares

• The market prices of preference shares fluctuate more when compared to debentures





Classification of Preference SharesClassification of Preference Shares

• Cumulative and non-cumulative

• Redeemable and Irredeemable

• Participative and non-participative

• Convertible and non-convertible





Internal Source of FinanceInternal Source of Finance

I. Retained earnings

II. Depreciation charge

• Factors influencing retained earnings:

Earnings capacity of firm

Types of dividend policy

Taxation policy

Profitable investment opportunity

Top management attitude and philosophy

Custom of industry

Industry life cycle




Chapter 12Sources of Long-Term FinanceEvaluation of Retained Earnings as Evaluation of Retained Earnings as

Source of FinanceSource of FinanceAdvantages to company:

• Easy to raise• Less costly• Increases credit worthiness• No dilution control• Helps maintain stable dividend policy• Acts as cushion to absorb hazards

Advantages to shareholders:• Share price goes up• Enhances dividends• Enhances collateral value of shares





Evaluation of Retained Earnings (contd.)Evaluation of Retained Earnings (contd.)

Disadvantages:• Limited funds available

• Creation of monopoly

• Loss to shareholders

• Lead to over capitalisation

• Misuse of funds

• Leads to evasion of super profit tax





Debenture CapitalDebenture Capital

Debenture is a security that is issued under a firm seal for receiving a sum of money.Features:

• Fixed rate of interest• Redemption• Debenture indenture• Convertibility• Clainon income and assets• Maturity• Call option• Security interest• Credit rating





Types of DebenturesTypes of Debentures

• Redeemable and Irredeemable

• Convertible and non-convertible

• Secured and Necked

• Registered and Bearer

• Zero coupon debenture

• Deep discount bond

• Floating rate bond

• Secured premium note

• Guaranteed debenture

• Cellable debenture





Evaluation of Debentures (advantages)Evaluation of Debentures (advantages)

To Company:• Cheapest source

• Trading on equity

• No participation in surplus funds

• Protection against inflation

• No loss of control

• Flexibility

To Debenture holders:• Fixed income

• Definite maturity period

• Safe and secured investment




Chapter 12Sources of Long-Term FinanceEvaluation of Debentures Evaluation of Debentures

(Disadvantages)(Disadvantages)To Company:

• Risky capital

• Comes with strings

• Increases Ke

• Costly (if irredeemable)

To Debenture holders:• No voting right

• Taxable income

• No claim on surplus income

• Loss of interest in inflation




Chapter 12Sources of Long-Term FinanceDistinguish between Equity Stock and

DebenturesPoint of Distinction Equity Shares Debentures

Nature of Security Ownership security Creditorship security

Form of Return Dividend Interest

Rate of Return Not fixed (no guarantee) Fixed rate

Refund of principle amount

May be refunded at the time of liquidation

Refunded at the end of maturity period

Voting Rights Have voting rights No voting right

Charge of Return Dividend is a charge against profit & loss apparition account

Interest is a charge on profit& loss account

Exemption of return from tax

Not exempted from tax (Dividend is paid after payment of tax)

Exempted from tax (interest is paid before payment of tax)

Claim on assets and income

Equity holder does not have claim on assets and income

Debenture holders have claim on assets and income





Loan FinancingLoan Financing

Features of Term Loans• Currency• Negotiable• Restrictive covenants• Convertibility• Repayment schedule• Maturity• Security





CovenantsCovenants

Covenants: Are the conditions imposed by the lender to protect his/her interest

Positive covenants:• Submission of financial statements• Maintenance of mini WC• Creation of reserve fund• Minimum network maintenance

Negative covenants:• Asset-related covenants• Liability related covenants• Cash-flow related covenants• Control related covenants





Sources of Term LoansSources of Term Loans

• Developmental banks

• Commercial banks





Causes for the Growth of Developmental Banks

• Absence of organized capital markets• Low capital information• Shyness of capital (investors preference to invest in safe areas,

and not interested to invest in new ventures)• Inadequacy of finance facilities for industrial development• Rehabilitation and revolution of war shattered economies• Planned economic development of a country• Shortage of foreign exchange.





IFCIIFCI

• Established in 1948

• Objective - provide medium and long-term loans to industries

• Financial Resources - paid up share capital; Reserves and surpluses; borrowing [rupee loan and foreign currency]; public deposits





Functions of IFCIFunctions of IFCI

I. Financial Assistance: Project Finance; loan guarantee; differed payment guarantee; underwriting of securities; direct subscription; acting as agent.

II.Promotional Activities: promotes entrepreneurship; encourages professional management; development of backward areas; encourages self employed persons; encourages small and medium industries.

III.Merchant Banking





ICICIICICI

• ICICI: Is a financial institution established for the purpose of developing industries in private sector


• Objective: Assist industries in private sector

• Financial resources: Share capital; borrowings from RBI, IDBI, LIC, UTI, IBRI, IDA, GOI





Functions of ICICI

• Granting long-term and medium-term loans to eligible industries,• Subscription to the equity, preference share capital and debentures,• Underwriting issue of shares and debentures, • Guaranteeing differed payments in rupees the cost of capital equipment

imported.• Expansion of investment market,• Encouraging and promoting private ownership,• Encouraging and promoting the participation of private capital. both

internal and external, • Assisting in the creation, expansion and modernization such units,• Provides financial services (like deferred credit, leasing, investment sale,

assets credit, venture capital, project advisory, custodial services etc.)





IDBIIDBI

• IDBI: Is a wholly owned subsidiary of RBI, established to discharge the role of a apex bank in development of banking


• Objective: To act as apex bank in industrial finance

• Financial resources: Share capital; reserve; borrowings from RBI and GOI; market borrowings from public; Foreign currency borrowing; World bank; ADB and international markets





Functions of IDBIFunctions of IDBI

I. Financial activities [Direct]

Lending; underwriting’; guaranteeing; venture capital; soft loan

I. Financial activities [Indirect]

Refinancing; direct subscriptions; Bills discounting

II. Developmental activities: promotion; Research; subsidiaries





SFCsSFCs

• SFC: Is the corporation established at state level to provide finance for industries

• Establishment: State Finance Corporation Act, 1951

• Objective: To provide medium and long-term loans to small and medium scale industrial units

• Financial Resources: Share capital; bonds; borrowings from RBI, IDBI; and SIDBI





Functions of SFCsFunctions of SFCs

• Loan guarantee

• Underwriting of issue

• Guaranteeing differed payment

• Providing foreign exchange loans

• Acting as a agent for central and state government and IFCI

• Granting loans

• Direct subscription of share capital





Innovative Source of FinanceInnovative Source of Finance

• Lease Finance• Hire purchase• Project finance• Venture capital• Bridge finance• Euro issues

Documents

Long Term Funds